How The Energy Boom Keeps Going

 |  Includes: CVX, LINEQ, ROYT, SLB, WFT, XOM
by: Kate Stalter

The energy arena is rife with new opportunities, boosted by new technologies, and underpinned by the income potential, says Elliott Gue of Energy & Income Advisor.

Nancy Zambell: My guest today is Elliott Gue, the editor of Energy & Income Advisor and Capitalist Times. His former colleague, Roger Conrad, is just coming over to join him, and I know you're excited about that, Elliott.

Elliott Gue: Absolutely. I worked with Roger for 13 years, and we've been in different companies for the last six or seven months. It's really good to be working together again.

Nancy Zambell: That's great. Why don't you tell me about your publication?

Elliott Gue: Sure. Energy & Income Advisor is a twice-monthly publication. And we do update in between issues with fairly frequent flash alerts and market updates.

Our coverage universe is really everything energy. We cover traditional energy stocks like the big integrated oil companies: Exxon (NYSE:XOM), Chevron (NYSE:CVX), etc. The oil services companies like Schlumberger (NYSE:SLB) and Weatherford (NYSE:WFT). And, of course, we cover a lot of the income-oriented sectors of the energy markets, including Master Limited Partnerships and royalty trusts.

Now that Roger Conrad is joining me, he's bringing his particular expertise in Canadian energy stocks to the table. We've added a large coverage universe of Canadian energy stocks, particularly those that offer very high yields.

Nancy Zambell: And yield is something that investors are really looking for today. Although the market has been just tremendous...I think people are started to get a little scared of it.

Elliott Gue: Absolutely, I think that. But if you look at a lot of the traditional income-oriented investments like government bonds, they're yielding next to nothing. Savings accounts are yielding next to nothing. So there's definitely a lot of appetite for companies or stocks that can offer you 5%, 6%, or 7% yields.

Investors just can't generate enough income to live on at 2%, so they're looking for higher yield. The trick, of course, is to balance that with risk. A lot of times those highest-yielding stocks also carry an awful lot of risk.

That's one of the things we focus on a lot—looking for stocks that not only offer well above-average yields of 5%, 6%, 7%-plus, but also the potential for growth in those dividends or distributions over time, and also safety.

Nancy Zambell: Within the energy sector, are there any particular subsectors that you're very fond of these days?

Elliott Gue: One of the sectors that we like the most, and we spend a lot of time covering, are MLPs, and I'm sure many listeners are aware of that sector.

About 80%-plus are involved in traditional midstream energy businesses. This would include owning oil and natural gas pipelines, or oil and natural gas storage caverns or terminals. Basically, anything to do with moving, transporting, or storing oil and natural gas.

There are also several names that are involved in the upstream energy business, actually producing oil and natural gas. And then there are a few involved in other businesses, like refining.

Traditionally, most MLPs in the midstream sector are very stable companies. They charge pretty much fixed fees to transport oil and natural gas, or store oil and natural gas, with very little commodity price sensitivity. They don't really care whether the price of oil running through their pipelines is $50 a barrel or $150 a barrel—it's really more of a fixed fee plus a fee based on the volume of oil transported.

So it's a very stable place. And if investors are worried about the potential for an economic slowdown as the cause—as we've seen every year over the last few years—another significant market correction, it's a very stable sector that also offers average yields of almost 6%. And there are several out there that are offering yields of close to 10%.

One company that's been in the news a lot lately, and not always positively, but I think it's a good value right here is Linn Energy (LINE). There was a very negative article in Barron's in early May concerning this stock. But if you look at the actual details of that article, a lot of it was arguments that have been rehashed for years now, and that I believe have been largely discredited.

At the same time, this is a company that produces oil and natural gas, but also hedges 100% of their output for four to six years into the future, so they have very little near-term commodity price sensitivity. And you're getting almost a 9% yield on that stock right now.

Nancy Zambell: Well, that's very healthy, isn't it?

Elliott Gue: It is; it's four times or more what you're going to get out of a Treasury fund.

Nancy Zambell: MLPs are required by law to return a certain percentage of their profits to their investors, correct?

Elliott Gue: Right, they are. Rather than looking simply at earnings or profits, I tend to look at what we call distributable cash flow, or DCF.

A lot of the traditional measures of earnings include accounting charges like depreciation and amortization and depreciation, and it's not really an upfront cash charge. It's a way that a company can charge the cost of an asset off their books over a period of many years. A lot of MLPs are involved in things like pipelines, which are large fixed assets which generate tons of depreciation.

So rather than looking at earnings, I like to look at distributable cash flow, which is simply the actual cash moving in or out of the company, minus a charge that we call maintenance capital spending—an estimate of how much the company has to spend just to keep its existing assets in good, serviceable working order.

And on that basis, most of these MLPs offer really solid coverage of their distribution, and the potential to really grow their distributions over time. Linn Energy, for example, recently announced that it's purchasing a company called Berry Petroleum (BRY), which is a major producer of oil in the state of California and elsewhere.

The increased production from the acquisition is going to allow them to boost their quarterly distributions from 72.5 cents all the way up to 77 cents a unit later on this year.

Nancy Zambell: That really adds to your returns. Now let's talk about energy trusts. Can you tell us a how energy trusts differ from the MLP formation?

Elliott Gue: Absolutely. It's a little different legal structure. Royalty trusts in the U.S. and Canada are also different.

A lot of investors probably remember five or six years ago, when the Canadian royalty trusts were very popular. These were companies in Canada that were normal operating businesses. They could go out and make acquisitions and aggressively drill on their properties when commodity prices were high.

U.S. royalty trusts are totally different animals. They're not operating companies. When a company establishes a royalty trust, they contribute certain assets to that trust. Over the life of that trust, they can never make an acquisition; they can never go out and do additional drilling on that property.

Everything that that trust owns or all their potential is in the trust when it forms, so they're not operating companies. That's the biggest difference between a royalty trust and MLPs.

The second one is that most of the royalty trusts are involved in actual oil and gas production, whereas the majority of the MLPs are actually in the midstream business.

Nancy Zambell: And are there any trusts that you like today that you would recommend?

Elliott Gue: Yes, there are a couple out there I would highlight. One of them is a little bit more of an obscure one that doesn't get as much press attention as some of the Sandridge trusts that people hear a lot about. It's a company called Pacific Coast Oil Trust (NYSE:ROYT).

What I like about them is that their acreage is primarily in the state of California. The reason that that's important is that oil prices in California are higher than anywhere else in the United States. The primary reason for that is that California does not actually have any major pipelines connecting it to other parts of the United States.

In Texas, for example, there's a lot of oil coming south from the Bakken shale in North Dakota, so it's very well supplied, and prices are down there. But there is no way for that Bakken crude oil from North Dakota to get to California, because there are no pipelines to do that. There are not even any convenient rail links on that route.

As a result, the majority of California's oil is imported from outside the United States—places like Saudi Arabia; also South America. And these oil grades are much higher priced. So oil that's actually produced in California—and it's still a large oil-producing state—is priced at a premium to oil produced pretty much anywhere else in the United States. Pacific Coast Oil Trust benefits from that price premium.

They also have a very interesting play, which is called diatomite formation. Diatomites are basically ancient plant life. It's a very shallow field, located around 900 feet below the surface. And using a combination of very intense drilling—drilling wells very closely together—and also some fracking-type techniques, companies have really been able to produce tremendous amounts of oil from this formation.

Pacific Coast Oil Trust—a sponsor of that trust—has agreed to drill an area of acreage which is partly owned by the trust over the next few years in this diatomite formation. I think that's going to be a real production growth driver for them.