Market Timers Can Bet On An Energy Sector Recovery Cyclical Resource Stocks Must Be Traded, Not Held

Investors with holdings in the Canadian energy sector have lost money on even the safest bets. A global oil glut, partly fueled by increased U.S. energy production, has depressed oil prices around the world. In Canada, where opposition to new pipelines has made it difficult for oil and gas producers to get their products to market, the slump has been especially painful.

My old friend Peter, a retired financial advisor who has been an active resource investor since the 1970s, said he was down about $400,000 on his energy stocks, despite focusing on large, well-capitalized energy companies with a long history of paying dividends.

“This is ridiculous,” he said during a recent game of billiards. “John Templeton said to buy at the point of maximum pessimism, so maybe this is a great opportunity. Or else it’s the end of fossil fuels in Canada.”

Figures at OilPrice.com show global oil prices are at a long-term low, with the slump especially painful in Canada, where pipeline opponents currently hold sway. As a result, Canadian crude oil futures trade at only a fraction of West Texas Intermediate (WTI). As of early December, the price for Western Canadian Select (WCS) oil was just US$26 per barrel, less than half the US$53 WTI price and near its 2016 lows, the site says.

The slump has depressed the share prices of several Canadian industry giants. As of early December Canadian Natural Resources (CNQ/TSX) and EnCana Corp. (ECA/TSX) were at their lowest since 2016, Tourmaline Oil Corp. (TOU/TSX) was trading at less than the $20 price at which it went public in 2010 and both Seven Generations Energy Ltd. (VII/TSX) and PrairieSky Royalty Ltd. (PSK/TSX) were below their 2014 issue prices.

In some cases, the falling share price means dividend yields have climbed to generous levels, providing a cushion against further losses — providing the dividends can be sustained.

For example, Enbridge Inc. (ENB/TSX), having recovered slightly from its low near $40 in October, pays an indicated annual dividend of $2.68 that yields 6.3% and the annual dividend of $2.76 paid to holders of TransCanada Inc. (TRP/TSX) now yields 5.1%.

Vermilion Energy Inc. (VET/TSX) and Crescent Point Energy Corp. (CPG/TSX) both trading at eight-year lows, pay dividends that now yield an astronomical 8.7%, while Peyto Exploration and Development Corp. (PEY/TSX), trading at a 10-year low, pays a dividend that yields 7.7%.

As for energy sector income trusts, Peter said he had once owned several, but noticed the unit value of many trusts fell by roughly the amount of the distribution. “This ‘return of capital’ business is basically just getting back your own money, like putting $100 into a safe and taking out $10 a year until there is nothing left after 10 years.”

Giant utilities such as Enbridge and TransCanada aside, the dismal long-term returns from Canada’s oil patch over the past decade or so has shown that energy sector holdings are not “buy and hold” investments but must be actively traded — bought when they are relatively low and sold when they are relatively high. If you buy oil and gas stocks and put them in the proverbial drawer like you might do with bank or telecom stocks, you may end up losing money in the long run.

In my opinion, some companies in the energy sector appear to be good turnaround candidates for risk-tolerant investors who can afford to wait for a recovery. Along with having the right temperament and sufficient money, however, those betting on a turnaround need to be young enough to wait for a rebound that may be many years away. Figures from Statistics Canada show a Canadian man who turned 65 in 2009 would have an average life expectancy of 18.5 years, a woman 21.6 years. That puts the average life expectancy of a Canadian man at about 83.5 years, a woman 86.6. Retirees betting on a stock to recover must keep this in mind, lest their goal be to enrich their heirs.

Those still determined to gamble on a rebound in the sector can hold units of an exchange-traded fund (ETF) that has a diversified portfolio of names. An ETF helps you avoid company-specific risk such as, for example, too much debt in relation to cash flow or assets. The recent record low price for most of the ETFs looks like a good buying-in point, but the risk is high — the funds could still go much lower. Here is a look at a few ETFs.

iShares S&P/TSX Capped Energy Index ETF (XEG/TSX)

The largest energy fund in Canada with $768-million in assets under management has occasionally brought big gains for investors, but the bad years have outnumbered the good. At a recent unit price of $9.48, down 29% since its peak in mid-July, the fund’s units are at their lowest since early 2016.

A long-term chart of the fund’s price illustrates how any investment tied to an underlying cyclical commodity must be traded to be profitable. Investors quadrupled their money between XEG’s launch in 2001 and its peak in May 2008, while those who bought when the fund was down in February 2009 and sold in two years later also made big gains. Aside from a brief run-up in mid-2014, it has been all downhill since then. The iShares site says that as of the end of October, the fund’s 10-year annualized return was minus 1.88%.

XEG carries an MER of 0.62%. The iShares site says that as of the end of October, the fund had 37 holdings, with fully 24.8% of its assets in Suncor Energy Inc. and 23% in Canadian Natural Resources Ltd. The remaining top holdings included EnCana, Cenovus, Imperial Oil, Husky Energy Inc., Vermilion Energy, Tourmaline Oil Corp., ARC Resources Ltd. and PrairieSky Royalty Ltd.

The 12-month trailing yield of 2.16% is eligible for a dividend reinvestment plan (DRIP) the iShares site says.

BMO S&P/TSX Equal Weight Oil & Gas ETF (ZEO/TSX)

Like XEG, investors in this fund have had to be active traders to make money. The BMO Global Asset Management site shows that as of Oct. 31 this $154-million fund had an annualized performace of minus 2.32% since its launch in 2009.

The fund’s holdings are concentrated among 14 companies, roughly equally weighted at about 7% of the fund, including Imperial Oil Ltd., Pembina Pipeline Corp., Cenovus Energy Inc, Seven Generations Energy, TransCanada Corp., Keyera Corp, Enbridge Inc., Inter Pipeline Ltd., Tourmaline Oil Corp. and ARC Resources Ltd.

The fund, which carries an MER of 0.61%, had as annualized distribution yield (which includes capital gains) of 2.9% and is DRIP eligible.

BMO Junior Oil Index ETF (ZJO/TSX)

This thinly traded ETF, launched in 2010, had $70.8-million in net assets as of Oct. 31, the BMO Global Asset Management site says. Like the other energy ETFs, unit holders were generally able to sell at a profit between 2010 and the peak in mid-2014, but since then annualized performance has been negative. The fund’s net asset value is down 2.08% since its launch, the site says.

Roughly three fourths of the fund’s 58 holdings are U.S. companies with exposure to oil, with Canadian names Vermilion Energy and ARC Resources also included among the fund’s top 10 holdings.

The MER is 0.6%, larger than its annualized distribution yield of 0.4%.

BMO Junior Gas Index (ZJN/TSX)

Like the junior oils, small companies in the natural gas sector are also suffering, as this fund’s annualized performance is a dismal minus 7.53% over the past five years. About two thirds of this fund’s $31.2-million in assets are in U.S. companies, one third in Canadian.

Among its top holdings are Canadian names Parkland Fuel Corp. (9.3%), Enbridge Income Fund Holding (6.8%) and Seven Generations Energy (5.9%).

The fund carries a management expense ratio of 0.58%, with an annualized distribution yield of 2.3%.

Horizons S&P/TSX Capped Energy Index ETF (HXE/TSX)

This fund’s units were $25 when it launched in 2013, fell to a low near $15 in 2016 and have slipped again to near $16.

The fund, with $21.7-million in assets as of Nov. 30, has no holdings but instead uses total return swap agreements with Canadian banks to track the daily movements of the S&P/TSX Capped Energy Index, including the dividends paid out. It carries a relatively low MER of just 0.25%. Although the fund’s net asset value includes the dividends in the index, the fund officially pays no distributions, which the Horizons site points out is a tax advantage.

Resource sectors are cyclical, which means they must be traded. Investments made in any company whose fortunes are tied to an underlying commodity means the company could get into serious trouble when the commodity price falls, no matter how well the firm is managed.

Investors who hold stakes in energy, minerals or forest products companies have little choice but to try to time the market by buying at what appears to be a low price for the commodity in hopes of selling higher later. Company-specific risks such as high debt levels can be reduced by holding exchange-traded funds that hold a diversified portfolio, but even these must be watched carefully.

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