Big Picture Trends for the Energy Industry and How Investors Can Profit

I recently teamed up with my colleague Jeff Kosnett to discuss developments in the energy sector, and how they translate into opportunities for investors. Below is a summary of our discussion. At the end of this article is a link to a recording of the conversation, which is free to Kiplinger Alerts subscribers.

Where are oil prices headed?

Markets have been volatile over the last few decades, which is a scary prospect for investors.

Why has the market been so volatile? The one-word answer is shale.

Crude oil recovered from shale has only recently become economically viable. Refinements in drilling technology – predominantly fracking and horizontal drilling – have opened a lot of formations for oil recovery.

In less than a decade, shale output has almost doubled the amount of crude oil produced in the U.S., which has had a dramatic effect on world oil markets.

Kiplinger thinks $50 per barrel will be the new normal for oil prices.

Many shale resources become economic at about $50 per barrel, which provides a stabilizing factor in oil prices. Prices will remain volatile, but on average they will hover around $50 per barrel for the foreseeable future.

How can investors profit in this environment?

Generally speaking it’s not a good idea to invest in mutual funds or oil stocks based on short-term price predictions. Some investors have made unfortunate bets on companies investing in new acreage or undertaking expensive capital projects just as oil prices collapsed. The safe thing to do is to look for iron-clad financial strength and great diversity.

Exxon Mobile (XOM) is a very reliable long-term investment that will faithfully pay a dividend, and they’ll raise it every year. No one project is going to sink them because it’s such a large company. Other large oil companies have run into problems because of a lack of diversity.

If you want to put money in the oil industry directly, buy an index fund like SPDR Energy Select Sector (XLE). The world spends a tremendous amount on oil every day, so you’ll always get a dividend.

As a general rule, the best policy with oil investing is don’t stick your neck out.

Pipelines and Oil Transportation

Millions of miles of pipelines cross the U.S. The companies that own and operate them don’t get paid based on the price of the commodity they transport, but on throughput.

So what’s going on with oil production?

The shale revolution has brought production up dramatically, almost to the high levels of the early 1970s. The outlook is even better because U.S. production will continue to grow. Production companies are drilling new, more efficient wells. The industry is much leaner and meaner, and production is on the increase. The U.S. will surpass its 10 million barrel per day peak later this year or next year. This is good news for the pipeline industry since there will be more demand for their services.

How can investors profit from increasing domestic production?

Most oil industry infrastructure – including pipelines, storage facilities and refineries – is owned by Master Limited Partnerships, which are publicly traded ventures that trade just like stocks. The larger oil companies spun off this infrastructure into partnerships to free up their own capital for exploration. Some MLPs are specialized on pipelines, or storage tanks, or retail stations. The biggest, Enterprise Products Partners (EPD), owns just about everything. For steady, reliable, no drama income, the larger partnerships are your best bet.

Another option that has often been recommended in the Kiplinger 25 is Magellan Midstream Partners (MMP), which controls a large amount of the distribution of gasoline, diesel and other finished products in the central U.S.

Despite fluctuations in price, these kinds of partnerships are going to have steady income in the coming years.

Investors who are not comfortable picking specific companies may prefer to invest in a mutual fund. A complicating factor with mutual funds that specialize in MLPs is that tax law prohibits these funds from placing more than 25% of their assets in partnerships and still qualify to be a tax-exempt pass-through mutual fund, so the fund has to pay 30% or more in taxes, which reduces your dividend.

A better option is Miller/Howard High Income Equity Fund (HIE), which has capped its MLP investment at 25%, with the rest of the fund invested in real estate investment trusts, utilities and other income-paying securities. This is a way to get about five or six very good MLPs without running afoul of the tax laws.

Having said that, it’s still best to pick the individual stocks if you can do that.

How do refineries fit in?

Oil must be refined before it’s used, so refineries are a key segment of the oil industry.

The demand picture for refined fuel is fairly steady over time. Demand took a hit during the Great Recession and hasn’t picked up that much since, despite a recovering economy. That flat trend is mostly due to increased efficiency, e.g., cars getting more and more miles to the gallon.

But that’s not the whole story with the demand for oil. The picture for overseas demand is much brighter, which has led to a sharp increase in U.S. exports.

Markets overseas – especially in emerging markets – are growing faster than the U.S., and there’s a growing worldwide middle class that needs gasoline and diesel.

The U.S. refining industry is very efficient, with excess capacity, so it’s well situated to take advantage of this growing foreign demand.

Other countries, including especially Latin American countries that produce a lot of oil, don’t always have the refining capacity to match their production, so U.S. refineries will continue to grow as they take up that slack.

Kiplinger forecasts continued growth in worldwide demand, which bodes well for U.S. refineries.

What investing opportunities exist in oil refineries?

U.S. refineries benefit from access to cheaper domestic supplies, which helps them make a better margin on the finished product.

A few options to consider for investors.

  • Valero (VLO)
  • Alon USA (ALJ)
  • Tesoro (TSO)

These firms are often structured so investors can choose a stock (e.g., VLO) or a partnership (e.g., VLP). The distinction will affect the tax treatment of your dividends.

Investing in refineries is much less volatile than other parts of the energy industry. Over the long term these investments have been very stable, and even as new technologies come along, the world is going to continue to require refined petroleum products for a very long time.

What’s the forecast for electricity?

Demand doesn’t look all that encouraging on the electricity side. Consumption has been flat for a long time, aside from seasonal variations.

While the economy is growing, energy efficiency keeps increasing as well, which keeps demand in check.

That doesn’t mean this isn’t a good area for energy investors. Electricity rates are another story and have increased gradually over time.

The electric industry is heavily regulated at the state and federal level. The regulatory bargain goes like this: As long as utilities are delivering reliable power, they are generally allowed to pass along the cost of infrastructure investments through increased rates.

While demand is very stable, prices do gradually rise, and there is continual investment in new capital, which creates investment opportunities.

Investment opportunities in electric utilities

The first thing to know about these investments is that they aren’t bonds in disguise. These are real businesses that grow and make a profit. They don’t necessarily see share prices go up or down with interest rates or inflation. Wall Street is only now catching up with the opportunities in this sector.

While there are plenty of good options in this space, here are three recommendations.

  • American Electric Power (AEP)
  • Xcel Energy (XEL)
  • NextEra Energy (NEE)

These firms take advantage of the regulatory system and pay decent dividends. They have benefited from inexpensive natural gas and the ability to invest in solar and wind. They’ve also increased their efficiency from consolidation through mergers and acquisitions. Total returns have been very reliable for a long time.

Investors can pick and choose any of these companies, or they can choose some mutual funds and index funds that specialize in the regulated utility industry.

Preferred shares can yield 6-7% while common stocks typically yield 3-4%.

In a few situations there have been some dividend cuts, but generally speaking these companies have tried to increase their dividends. Common stock dividends are taxed at an advantageous rate, so on an after-tax basis, these investments are comparable to a municipal bond.

What’s Next with Wind and Solar?

While renewable energy is a very small percentage of our total energy picture, it’s growing rapidly.

Don’t get distracted by the solar panels on your neighbor’s roof. The utility industry has been the biggest installer of new solar capacity. Solar panels are increasingly efficient and are coming down in cost.

There’s also a lot of growth in wind energy.

In some months, wind generates as much power as hydroelectric dams. Also, government policy is encouraging renewable power with federal and state tax credits. In addition, some states mandate that utilities acquire a percentage of their power from renewable sources.

With both a push and a pull – from better economics and government subsidies – there’s been an increase in investments in renewable power.

Investing options

Any time there’s a new growth industry, Wall Street isn’t far behind in constructing some sort of investment vehicle to send some of that cash back to shareholders.

About five years ago, some of the independent power producers that used to be in the oil and gas business decided to get into renewables. While utilities continue to invest in power generation, and some invest in renewable facilities, a lot of the growth has been from independent power producers – either the true independents, or spin offs from the utility companies. These spin-offs are called Yield Cos. They finance the creation of commercially viable, large-scale renewable power and supply it to the rest of the supply chain. Prices move around a lot, but this is an opportunity to take a shot at larger yields – up to 8 percent.

Options to consider include the following.

  • Atlantica Yield (ABY)
  • NRG Energy (NRG)
  • Brookfield Renewable Partners (BEP)

Webinar-On-Demand Series

This special presentation was one of the four annual webinars included in your Kiplinger Alerts subscription. If you would like to listen to the entire presentation, here’s a link.