Based on prices for the benchmark West Texas Intermediate Crude (WTI), oil has once again pushed above $95 a barrel. A blast of cold weather has lifted North American natural gas back over $3.50 per thousand cubic feet, at least for the moment. That’s good news for the price of electricity, as well as for fuels such as coal and propane. And prices are considerably stronger elsewhere in the world.
Given the continuing concerns about global growth–and the impact of unfolding US austerity measures–that’s actually not a bad price environment for energy. And there’s real reason to expect further improvement in 2013, now that economic growth in China is picking up.
The world’s most important driver of oil demand reported growth of 7.9 percent in the fourth quarter of 2012, up from a nadir of 7.4 percent in the third quarter. China’s economic growth is now expected to come in around 8 percent for 2013, a pace that would almost certainly sustain the trend of rising demand for energy imports.
Ironically, improved prospects for energy prices don’t appear to be benefitting stocks of most producers. Shares of oil and gas companies that pay big dividends have been particularly weak, as investors question the safety of their high yields.
To be sure, there’s good reason for at least some caution. This week, for example, Canadian intermediate producer Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) cut its monthly payout by 42 percent. That follows reductions at several higher profile and more widely owned Canadian companies last year, including Enerplus Corp (TSX: ERF, NYSE: ERF), Pengrowth Energy Corp (TSX: PGF, NYSE: PGH) and Talisman Energy (TSX: TLM, NYSE: TLM).
Canadian producers’ profits have been hurt by the differential between oil pumped in Canada and the WTI price. Canadian crude has historically traded at a discount of about 5 percent to WTI, primarily due to the greater distance to the major refineries on the US Gulf Coast. In recent months, however, the discount has widened to 10 percent, as rapidly rising output on both sides of the border has temporarily overwhelmed transport capacity.
Arbitrage possibilities are spurring a surge of new projects, including rail capability, that will eventually cut these differentials. Meanwhile, the differential between WTI and Brent Crude promises to narrow as well, as new pipelines connect the Cushing hub in Oklahoma with the Gulf. But at this point, companies are coping with pressure on cash flow. And rather than abandon development plans or roll up debt, at least some producers are making up the shortfall by paying out less.
Prices of the new breed of energy royalty trusts have also suffered greatly in recent months. These companies pay distributions from royalties based on others’ output from lands they control. SandRidge Permian Trust (NYSE: PER), for example, derives royalties from output pumped by SandRidge Energy (NYSE: SD) in the Permian Basin.
Distributions depend on the amount produced and the price obtained for it. The good news for Sandridge Permian Trust is the drilling program on its lands is very much on track with the expectations laid out in its initial public offering (IPO) filings in August 2011. The bad news is oil and gas prices have been volatile over that time, resulting in some ups and downs with the dividend. And judging from the volatility in its unit price, that dynamic was not well understood by many who jumped on the IPO.
As a result, after a big run higher in early 2012, units of SandRidge Permian Trust are now basically back around the IPO price, after falling below it for a time. The indicated yield of more than 13.5 percent clearly shows a high level of investor skepticism about the enterprise. Other trusts trade at similarly low valuations, despite arguably being more valuable after reporting solid progress with well development.
Master limited partnership (MLP) producers are a third group of high-yielding energy equities that has recently underperformed. MLPs are generally set up to limit distribution volatility, focusing on high-percentage production opportunities and by hedging selling prices liberally. As a result, group distributions have remained stable to rising. BreitBurn Energy Partners LP (NSDQ: BBEP), for example, has now raised its payout for 10 consecutive quarters, as it’s steadily boosted output and cash flow.
That hasn’t stopped producer MLPs’ unit prices from being volatile, however. BreitBurn’s unit price has rocketed higher since the beginning of the year, thanks to successful asset additions and distribution growth. Others such as Linn Energy (NSDQ: LINE), however, are still well below October highs, despite having hedged selling prices for all of its prospective oil and natural gas production through 2017. And QR Energy (NYSE: QRE) units are down by more than 16 percent over the past 12 months, despite two distribution increases over that time.
The primary takeaway here is high-yield energy producer stocks do follow oil and gas prices, even if earnings are insulated from volatile commodity prices. That trend is likely to continue in 2013. And to the extent that US austerity cuts into global growth, investors need to expect near-term downside in share prices, and potentially even in the dividends of some producers if the impact is severe enough.
However, now is not the time to give up on high-yield energy. For one thing, it’s likely that Canadian producer stocks, US royalty trusts and US MLPs are already pricing in quite a bit more downside for oil and gas prices than is likely to happen. Producers have also been living with volatile energy prices for a while. As a result, leverage is low and dividends have a considerably greater cushion than they did even last year.
Most important, the long-term prospects for energy prices are still quite bright, as demand continues to rise in the developing world. And North American energy producers are in particularly good shape to take advantage of rising demand, as output ramps up from shale reserves.
Until enough pipelines and other transportation systems are built, price differentials will remain a problem in some areas, particularly the Bakken region in the upper Midwest and southwestern Canada. And that will affect profitability and possibly even drilling activity for North America producers operating there.
But there’s clearly future demand for these resources. And sooner or later, it’s going to drive producers’ output, cash flow, distributions and share prices higher.
No one should be under the illusion that profits and dividends paid by high-yielding energy producers are as safe and steady as pipelines and utilities. But over the long term, there should be ample upside. And if inflation does rear its ugly head in coming years, dividends paid by energy producers will more than keep pace.
The way to control risk in an income portfolio is not to try to limit the volatility and near-term downside of every holding. Rather, investors must diversify among high-quality, growing companies drawn from a range of sectors that profit best in differing environments.
Our companies will grow over time, building dividends and wealth. Meanwhile, owning a range of sectors–including high-yield energy–ensures we’ll always be invested in something that’s gaining value, no matter what the future brings.
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