A gusher of reasons to buy energy funds

Since equity markets bottomed out two years ago, Canada’s S&P/TSX Energy Index has shot up by a whopping 70%. That a big enough surge to beg the question: are the good times over, and is the sector due for a downturn?

Since the beginning of the year, several key developments have helped to boost the outlook for oil and gas prices. First and foremost is the recurring risk of inflation.

The unwillingness of governments to cut their budget deficits has made higher prices all but certain in most developed countries. In the U.S. in particular, the mounting deficits and debt are untenable. But instead of cutting expenditures and raising taxes, which is politically suicidal, governments seem to be inducing inflation to make debt easier to repay.

For the same reason that inflation is harmful to savers, it’s good for long-term debtors, because it lowers the real value of the interest payments. That’s why governments with high debt have an incentive to encourage inflation. In his book The Age of Turbulence, Alan Greenspan forecast a 4% inflation rate for this decade, mostly due to structural budget deficits. (A structural deficit is one that cannot be eliminated without major taxing and spending policy changes.) But that was before the crisis of 2008. With the binge spending and loose monetary policy of the past three years, inflation is likely to get worse than 4%. Prices are currently moderate on most consumer items, so this sounds like next year’s problem. But markets anticipate what will happen next.

The problem is, inflation and high commodity prices — including oil and gas prices — tend to feed on each other in a vicious circle: people stock up on commodities to hedge against inflation, which leads to even higher prices, and thus inflation continues to rise.

The second development that bodes well for energy stocks is Japan’s nuclear crisis. After what happened in Fukushima, nuclear energy has suddenly become unattractive, both politically and environmentally. The obvious alternative is natural gas, which will increasingly replace nuclear reactors for generating electricity.

The third development is political uncertainty in the Middle East. Recent events in this region, which produces about one third of the world’s oil supply, have pushed oil prices above $120 per barrel.

Needless to say, higher prices do wonders to the profitability and cash flows of oil and gas companies. For these companies, the cost of production is pretty much constant, so every extra dollar in the selling price goes straight in their coffers.

Right now large oil and gas companies are trading at cash flow multiples of 9 to 10 times, which is on the high side. However, when recent price increases are factored into this year’s results, those multiples will suddenly look much more attractive.

As Canadian investors, our options for getting oil and gas exposure abound. To start with, the S&P/TSX Composite Index is more than 25% energy stocks. So even a broad-market Canadian mutual fund may have more than enough oil and gas exposure for a regular investor. But if you want more, you can always buy an energy fund.

There is no separate investment category for energy funds: they’re typically included with natural resources funds. But in the graph Cooking with gas I have provided a list of pure, actively managed energy funds for you. In order to select a suitable one, first consider whether you want purely Canadian exposure, or whether you prefer to diversify into global energy funds.

Keep in mind that the moment you go global, some additional risk factors come into the equation, including foreign currency fluctuations. Historically, the Canadian dollar tends to appreciate with higher commodity prices, as Canada is largely a resource-based economy. Therefore, investing in a fund with exposure to foreign energy stocks is a bit like a tug-of-war: some of your gains may be offset by currency depreciation.

Your second consideration is whether you want a fund with small-cap or large-cap focus. Small energy companies produce less and have fewer exploration fields, so when they have a major strike, their price skyrockets. They also tend to benefit more from higher prices. On the other hand, those companies have limited access to financing, and less capacity to withstand long cyclical downturns. In summary, investing in small-cap producers can be very rewarding, but it’s not for the faint of heart.

Looking closer at Cooking with gas, you will see that CIBC Energy and Bissett Energy have scored the best results, buoyed by high exposure to Canadian small- and mid-cap companies. RBC Global Energy also has some focus on smaller companies, but the non-Canadian component of its portfolio has suffered from the rising Canadian dollar. The fourth-best performer, Altamira Energy, places more emphasis on mature, large-cap Canadian producers. For that reason, it is slightly less volatile than the other two.

No matter what you choose, keep in mind that energy funds are almost twice as volatile as regular equity funds. Even though the long-term outlook remains promising, you can never ignore the risk of a cyclical downturn. Energy funds lost 40% or more of their value between June 2008 and March 2009. That’s an indicator of how bad things can get when the market turns against you.

For the risk-conscious investor, the ideal alternative is a fund that invests in high-yield energy stocks. The beauty of these funds is that they can cope with most economic situations. When the economy is strong and inflation is high, interest rates go up, but so do oil and gas prices. That strengthens the balance sheets and cash flows of energy companies. When the economy is weak and inflation is under control, lower commodity prices negatively affect cash flows and may result in dividend cuts. However, this risk is mitigated by the likelihood of lower interest rates, which makes dividend yields more attractive. Either way, financially sound, high-yield energy stocks tend to fare well.

In the good old days, when income trust funds were still around, it was easy to find one with exposure to high-yield energy stocks. Until last year, we had a respectable number of income trusts with high energy exposure yielding 7% or more. When the new tax laws came into effect, those trusts converted into corporations. Meanwhile, income tax and higher share prices have reduced dividend yields by half (when the share price goes up, the dividend yield goes down), but those yields are still attractive.

As a result of the mass conversion of income trusts into corporations, the former income trust funds have now morphed into balanced funds, high-yield funds, or small-cap funds. So you need to dig deep to find those with significant exposure to high-yield energy corporations.

For that, you have to look at the portfolio holdings as well as the dividend distributions of each fund. I stress the word dividend here because mutual fund distributions include several components: dividends, capital gains and return of capital. What matters most is the dividend income, because these payments come from surplus cash flow. Capital gains are more unpredictable, and return of capital is simply your money being handed back to you.

Separating out the dividend distributions from the others sounds tedious, and it is. However, you don’t need to worry, because I’ve done the work for you. In the graph “A safer bet,” I have listed six options with a healthy exposure to high-yield energy stocks. I selected funds with a minimum estimated portfolio yield of 2% and a minimum exposure of 30% to the energy sector. This is to ensure that a substantial portion of the dividend income is derived from energy stocks, which makes the fund less vulnerable to inflation.

If you want a lower-risk alternative to hedge against high energy prices, I would suggest that putting some money (say 10% or 15% of your portfolio) in one of these funds is a suitable choice.