Gil’s Musings

Preparing for Rebound in Energy Stocks

Last month, I wrote about how low oil prices are likely to benefit the U.S. economy by acting as a tax cut. That’s great for most consumers, but what if you’re an investor in the energy sector?

The price of West Texas Intermediate crude has fallen more than 50 percent since last summer. Oil companies are cutting production, laying off workers and re-evaluating their capital spending as their stock prices fall.

For investors, though, declining oil prices offer the same opportunity as falling stock prices: a chance to buy low.

In the short-term, there’s a lot of disagreement about what oil prices will do and how long they will remain low. The economies of Asia, a key energy consumer, are slowing and Europe is on the verge of deflation. Despite the cutbacks by oil companies, U.S. production is expected to increase at least for the first half of this year, adding to pressure on prices.

But the long-term story for oil and natural gas remain unchanged. Hydraulic fracturing has opened up new reserves, but oil and gas remain finite resources. Global demand for energy is not going to wane over the next decade. China and India alone are working to lift billions of their citizens out of poverty, and they need energy to do it. Much of that will come from oil and gas.

Additionally, as exploration and production companies cut their drilling budgets, oil supplies are likely to get crimped at some point in the future. Many investors don’t realize how steep the decline curves are in the new horizontal fracked wells that have fed the U.S. production boom. It is quite likely that the abrupt drilling cutbacks will lead to diminished supply far quicker than most realize. Patient and risk tolerant investors could be rewarded for waiting for others to be surprised.

In other words, if you’re willing to ride out some volatility over the next couple of years, there are lots of good investments in the energy sector.

For example, you might decide that the outlook for exploration and production is too risky for your investment needs, but the “midstream” business – pipelines, storage and gathering systems – offers more stability. After all, pipeline operators are basically toll collectors. They care less about the price of oil than they do how much of it is moving through their networks.

Many pipeline companies are also master-limited partnerships, which offer certain tax benefits to investors. MLPs were popular as the U.S. energy industry boomed, but they remain some of the best buying opportunities in the energy sector.

Refiners also offer a way to play off the oil price decline. They have to buy crude oil to process into gasoline and other fuels, so lower oil prices actually help their profit margins. In recent years, several integrated oil companies have spun off their refining businesses, offering investors a broader choice of pure refinery plays.

For investors who don’t have the time or the inclination to analyze individual stocks, energy-focused exchange-traded funds offer exposure to the energy space while shielding them from some of the volatility that comes with fluctuating oil prices. With ETFs, you can target a specific sector of the energy industry, such as oilfield services or exploration and production.

The midstream business, for example, has an ETF, the Alerian MLP, that contains names like Enterprise Pipeline Partners and Energy Transfer Partners. The energy sector ETF is represented by the Energy Select Sector SPDR (XLE), which contains 45 stocks. Remember that the fund is capitalization weighted, so the biggest companies get the biggest allocation in the fund. Accordingly, Exxon and Chevron alone comprise almost a third of the fund’s assets. The fund charges just 0.15% annually for keeping the fund together and accounted for. If you like the racier service sector, you can buy an ETF for that too. Schlumberger and Halliburton would be typical holdings in either the PowerShares Dynamic Oil & Gas Services ETF (PXJ) or the Market Vectors Oil Services ETF (OIH).

ETFs don’t often change their holdings by buying or selling stocks. That usually results in lower costs and lower taxes than other types of funds. ETFs are also structurally different than a typical open-ended fund like you might see from Fidelity or Putnam.

When buyers and sellers of ETFs don’t match up in the open market for shares, underlying securities are added or redeemed from the fund. But unlike an open-ended fund, the underlying share activity takes place in the open market, rather than within the walls of the fund. This means that ETFs are unlikely to generate a year-end capital gain distribution. This provides better deferral of taxable profits and adds compounded return to shareholders.

Because of their concentrated risk, ETFs offer investors the chance to get the most out of the energy rebound. Be aware, though, that in the short-term, they also can intensify any additional decline in oil prices. Given the long-term outlook for global oil demand, it’s a risk that for many investors may be worth taking.

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