An Oil And Gas Portfolio Long On Dividends, Short On Risk

by: Efficient Alpha

By Joseph Hogue, CFA

Geopolitical tensions have pushed oil back to the top of traders' screens and made energy the favorite guessing game for television pundits. As analysts try to determine the critical point at which the price of oil detracts from economic growth, the price of natural gas reaches 10-year lows. While only the most brave, or the most dramatic, should attempt a play-by-play call on energy prices most will agree that energy should be included in a diversified portfolio.

Outside of the trader's dream of scoring big on a future bet, most investors are better off with a well-diversified portfolio of energy companies that will provide a reasonable income return and decent prospects for appreciation.

The selection of five investments provides diversification across upstream, midstream, and downstream energy operations as well as geographic diversification in the two larger companies. The selection also spreads risk across industrial and retail customers to smooth out economic cycles. Three of the five investments receive favorable tax treatment under the U.S. tax code, giving the companies a competitive advantage against incorporated competitors.

Margins for petrochemicals companies from using natural gas liquids (NGL) are extremely attractive right now because of the spread difference between oil and natural gas. With production booming out of the North American shale plays, this relationship should hold for the foreseeable future and will drive infrastructure needs to meet the growing demand.

The NGL story is so strong right now that the U.S. became a net exporter of propane and butane in 2011 and could start exporting amounts of ethane as well.

Jeremy Grantham of GMO recently told Barron's that the opportunity provided by 10-year lows in natural gas were, "dazzling," and named energy in general as one of his long-term investment themes.

Master Limited Partnerships have been popular lately as a high-income play on the energy sector. MLPs are a special type of company under the tax code. Like REITs, they are exempt from corporate taxes as long as a certain percentage of income is returned to the general partner (management) and limited partners (investors). MLPs trade on the exchanges like stocks but typically pay much higher dividends, which are called distributions. For the pipeline operators, MLPs may also be a more stable play on the energy sector than traditional integrated firms because profitability is exposed to volumes rather than prices. Though prices for natural gas may be dropping precipitously, volume transported is more stable so business is less volatile.

Investors do need to understand the complicated tax structure for MLPs. Around 80% of distributions are taxed as a return of capital and payable on sale of the stock, but roughly 20% of distributions are taxed in the year received at the investor's marginal rate. Beyond this, there are some situations where distributions in a tax-deferred account may be subject to taxes so investors should look further into details relating to their particular situation.

Integrated Oil & Gas

With a market cap of $216.7 billion, Chevron (NYSE:CVX) is by far the largest in the portfolio and provides the most diversification. The company engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. Operations include both upstream (exploration & development) and downstream (refining & marketing). The shares are up about 6.5% over the last year and pay a reasonable 3.0% dividend yield.

Oil & Gas Operations

Hess Corporation (NYSE:HES) is a $22.2 billion exploration & production and refining company dealing in crude oil and natural gas. The company has significant operations and sales internationally giving the portfolio geographic diversification. Hess had some trouble in 2011 with weather delays, the loss of Libyan production, and a fire at Valhall. Smoother operations this year, as well as improvement in its Bakken development could set the company up for signification upside. The share's dividend yield is basically marginal at 0.6% but the stock brings great diversification and upside price potential to the portfolio.

Linn Energy (LINE) acquires and develops oil & gas properties across the United States. Shares are basically flat over the past 12 months but pay a distribution of 7.4%, the highest of the group. Bloomberg reported Tuesday that Linn agreed to pay $1.2 billion for BP's natural gas holdings in Kansas, increasing proved reserves by 730 billion cubic feet. The company has entered into hedging contracts for 100% of natural gas production and 68% of NGL production for five years giving the company plenty of time for natural gas demand to increase to meet supply. The company has completed a little over $4 billion in acquisitions over the past two years making it an extremely strong player when prices do rebound.

Natural Gas Utilities

Kinder Morgan (NYSE:KMI) is one of the largest pipeline operators in North America with roughly 37,000 miles of pipeline and 180 terminals. Products transported include natural gas, refined and crude petroleum, ethanol, coal and carbon dioxide. The distribution has not been as high as other MLPs at 3.7% but appreciation in the shares has been a strong 18% over the past year.

Enterprise Products Partners (NYSE:EPD) provides midstream energy services to producers and consumers of natural gas, natural gas liquids, refined and crude petroleum and petrochemicals. The company operates approximately 50,200 miles of onshore and offshore pipelines and 192 million barrels of storage capacity for NGLs. Shares pay a 4.8% distribution and enjoy the tax benefits of a master limited partnership.

Not all is golden however, the weakness in natural gas is forcing some companies to decrease production and total rig count has been decreasing with only about 71% utilization. Fortunately, many companies are hedging their exposure to gas and the overall portfolio provides broad diversification across products.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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