Time to Go Yield Hunting!

By Martin Tillier

Traditionally, a large part of the appeal of the energy sector for investors has been its propensity for larger than average dividends. Over the last few years though, as lower than anticipated oil and natural gas prices have put pressure on oil companies’ profits, there was an expectation that even the once reliable dividend payers would have to cut their payouts.

When the entire world’s economy shut down for a month or so earlier this year, forcing the price of the front contract for WTI into the negative, that process got hastened. Drastic cuts to dividends, and even in some cases their complete elimination, happened throughout the sector, from oil producers to pipeline companies and oilfield service businesses.

It would seem now though that there is not a lot left to cut, and with oil having recovered somewhat it is a good tine to go dividend hunting again!

Can Oil Stocks Go Any Lower?

The obvious, and perfectly correct answer to that question is yes, of course they can. In theory even massive historic companies can go under, effectively driving their stock to zero. Plenty of older people who held the “mighty” GM for years before their bankruptcy following the last recession know that all too well.

It doesn’t even have to be as final as bankruptcy either. Look at the once all-powerful GE, whose stock dropped below $10 in 2018 for the first time since the Great Recession and has only traded above that level for a couple of months since.

In both cases, iconic companies that had survived through thick and thin finally hit the point where they just kept going down.

That could happen to traditional energy stocks, but a better question is: “Is it likely to?” The answer to that would appear to be no.

Take a look at the chart for XLE, the energy sector ETF, above. As you can see, we are now not that far off the lows in March. Lest you forgot, that was a time when the roads and skies all around the world were empty. Oil consumption was as close to zero as it can ever get.

Things have improved so far from there that current levels look oversold by comparison.

I Thought You Were Bearish on Stocks Right Now?

If you follow me closely, whether as a subscriber to Energy Income Trader where I give actual trades based on my analysis, or a reader of my Nasdaq.com daily column, or anywhere else you may hear or read my thoughts and words, you may know that I have a decided short bias for the stock market at the moment.

That, however, is about valuation. Stocks overall are just too high given the current situation and risks. Energy, however, where the kind of irrational exuberance that has led to every conceivable bit of good news over the next year or two being priced in, has no such problem.

In fact, up 35% from the March low but down 50% from the start of the year sounds about right to me for the sector as a whole. There are still risks, but they are priced in here, and there is always a chance of a solid recovery lasting until a vaccine and/or cure is found, rather than a second and third wave and another shutdown.

The point is, with all that pessimism and bad news priced in, energy stocks could go lower, but it looks unlikely. That doesn’t necessarily mean we ae going a lot higher in a hurry, but for a dividend play you just need to believe that losses to your capital will be minimal, if any.

So, What Should You Buy?

The first thing to do is to set a few parameters for yourself. You want to look for big names in the sector that fit the value profile outlined above, so stocks that are closer to the March lows than the early year highs.

Second, you want some diversity, both in terms of industry and size of yield.

Third, you want companies with decent cash flow.

Using these criteria right now, my top two picks would be Chevron (CVX) and the MLP ETF, MLPA.

CVX

I would definitely look to hold a large U.S. based, diversified multinational right now. Their exposure to every part of the oil business, from drilling for crude to retailing gas, and their presence in other energy areas, gives them some protection from regular fluctuations in oil prices.

Some might think that the election poses a danger to companies like CVX, with a more alternative energy-focused and environmentally aware Biden leading the polls, but that isn’t as much of a worry as it may seem, for a couple of reasons.

First, President Trump has been desperate to prove himself a friend of the industry, but all the relaxing of regulations and encouragement of drilling everywhere can be seen as contributing to the low prices that we have seen. Tightening things up a bit would reduce supply and raise costs and barriers to entry for smaller, upstart companies, giving big oil back their edge.

Second, Joe Biden’s action over the last 50 years in government probably speak louder than his words, and on that basis, he is probably not going to pursue a radical agenda if it hurts the economy, and therefore his political prospects, no matter what he might say now.

Without that risk, and with positive free cash flow and a forward annual dividend of close to 7%, CVX looks like a buy.

MLPA

MLPA is an ETF that invests in Master Limited Partnerships (MLPs). They are what is known as “pass through entities” which is to say that they must pass on a large percentage of their profits to shareholders, and for various tax reasons they are popular among energy pipeline companies in particular. They therefore typically have large, if somewhat inconsistent payouts.

An ETF like MLPA spreads the risk involved in individual MLPs somewhat, but still offers a hard-to-beat dividend, or rather distribution yield. At the time of writing, MLPA has a distribution yield of 17.28%. That is attractive at any time, but with 10-Year Treasury yields hovering around 0.7%, it is spectacular!

If you are in the latter stages of your investment career and looking to finally draw some income from your portfolio, then now, with energy stocks dropping back towards their lows, may be a good time to consider them as yield opportunities. I’m not saying you should put everything into them by any means, but allocating a percentage of your portfolio and splitting it between the two names above for an average 12% yield will add significant juice to any bond fund returns.

Cheers,

M

Want more stories like this one?

After 10 years of underperformance from energy, stocks in the sector look set to break out this year. That means tons of opportunities. Follow best-selling financial writer Martin Tillier as he reveals how to capitalize on these opportunities..