Income investors over the past couple of years have had it rough. The competitive yields that once existed in CDs and Treasuries are a thing of the past. Income investors were literally forced out into the equity markets in an attempt to find the yields they were accustomed to. The problem they encountered is that the markets have proven to be very volatile based upon a host of factors and reasons. If there is one thing that income investors dislike, it is volatility.
One place that many income investor found themselves drawn to was the energy sector. Initially this seemed like a safe bet. The concept was that energy is always in demand, and every year we use more and more. Unfortunately this idea did not pan out as well as many income investors had envisioned. Natural gas prices fell to unprecedented lows, and the price of oil has been on a proverbial roller coaster as the world's economies teeter on the brink. As a result, some of the most loved income names in the energy sector saw their share prices decimated. Investors tripped over each other as they scampered for the exits.
So will the energy sector ever return for the income investor? The answer is of course yes, but the real question is when will that happen. No one knows the answer to that question, but when one looks around at global events, it is not hard to see that higher energy prices will return at some point. Saber rattling by the Iranian government, general discontent in the Middle East, and China's ever increasing appetite all but ensures energy's return at some point. The question is what income stocks will do well at that time. The answer is that most any stock related to energy should do well, but there are certain ones that may outperform.
Enerplus Corporation (ERF)
In the past ERF was one of the darlings of the income investor. This company was a dividend machine and investors would flock to it in droves. What was not to like about it? ERF's story was a classic success story as the company engaged in the exploration and development of crude oil and natural gas in United States and Canada. Take a look at the chart to see what happened next.
Needless to say, a slide from $30 a share down to $12 was a bit of a shock for any income investor. It left many scratching their heads wondering what happened. Of course nothing is easy and there were many factors involved, but with lots of exposure to natural gas and its plummeting price, it's not hard to figure out. In the past ERF's production was roughly 50% liquids and 50% gas. When the bottom fell out of the natural gas market, it became very worrisome to investors if ERF could continue operations and still fund the dividend distribution. As a result the stock sold off.
In mid-June of 2012, income investors' fears were realized. ERF came out with an announcement that despite their operational success, they were reducing their monthly dividend from CDN$0.18 per share to CDN$0.09 per share. Unfortunately the perfect story landed right on top of ERF. and the stock price suffered.
Let's face it: ERF looked like it was on the ropes, but that was not the case. ERF is a well-run company who just found themselves in the wrong place at the wrong time. In the latest company presentation, ERF has identified over 200 drilling locations on their oil assets, and over 575 locations on their natural gas/liquids assets. This means that ERF still has lots of potential to grow when energy prices return.
Of course ERF is not going to wait around until energy prices rebound. In 2012 their capital program is forecast to deliver 10% production growth. The total 2012 capital budget is said to be around $800 million. Of that number, 70% of capital is being directed toward oil and natural gas liquids projects. This should make for a 22% growth rate in oil production for the company. So it seems that ERF's management knows that the key to their future lies in the oil and natural gas liquids, so that is where the focus will lie.
Finally if one looks at ERF's hedging, it can give a clue to see where the company will benefit if energy prices do rebound in a meaningful way. For 2012, 62% of net oil production is hedged at US$96.22/bbl. There are also physical fixed price contracts in place for 48% of net natural gas production at $2.19/Mcf from August to October 2012. For 2013, 42% of net oil production hedged at US$103.00/bbl, and there are no natural gas hedges in place at this time. So currently ERF has 6% less of oil production hedged as it moves into 2013. What has been hedged is $6.78 greater than what has been done in 2012.
The bottom line is that ERF has cut its dividend to conserve cash, kept up with it capital development, and still looking to grow. If energy prices do make a comeback, ERF should be in a place to do the same. Until such time, ERF yields roughly 7.7% at the time of this article.
Pengrowth Energy Corporation (PGH)
If an income investor has heard of or knows about ERF, then the odds are good that PGH is on his radar screen as well. Pengrowth Energy Corporation is a company that engages in the acquisition, exploration, development, and production of oil and natural gas reserves in the Western Canadian Sedimentary Basin. It primarily explores for crude oil, natural gas, and natural gas liquids in the provinces of Alberta, British Columbia, Saskatchewan, and Nova Scotia.
On the surface PGH and ERF look remarkably similar in their story. Like ERF, PGH had a lot of exposure to natural gas and the volatility in pricing. As the bottom fell out of the gas market, so did investors' confidence. In the end this proved to be rightly so as PGH, much like ERF, was forced to slash their dividend. Below is a chart of the performance of PGH over the last year.
PGH's strategic plan closely mirrors that of ERF's. The company needs more exposure to the liquid side of the house. Unlike ERF though, PGH has decided to go about the process in a slightly different manner. As a result, on March 23, 2012 the company announced a strategic combination of Pengrowth and NAL Energy Corporation. The deal focused on the exchange ratio of 0.86 of a share of Pengrowth for each share of NAL.
The effects of the merger are to have a major impact on PGH. Management has stated that this transaction makes PGH the second largest intermediate producer in Canada. Also Pengrowth is expected to have an improved ability to internally fund the significant portfolio of oil-weighted development opportunities of the combined operations.
PGH also has a healthy capital expenditure plan in place for 2012. For the first quarter of 2012, Pengrowth spent $153.7 million on capital expenditures excluding property acquisitions and dispositions. Approximately 80% of the capital expenditures were spent on drilling, completions and facilities, with the remaining 20% spent on land, seismic and maintenance capital. The total 2012 guidance for the year is $625 million.
PGH's production profile shows that approximately 75,618 boe per day are generated by the company. The current breakdown is 53% liquids and 47% gas. The current hedging that is in place for the company is as follows:
Basically what it boils down to is that PGH, though beaten down, is trying to get its strategic assets into place for the future. With a new focus on liquids, PGH and its stock price should do quite well when the energy markets return. Until such time, PGH yields roughly 7.3% at the time of this article.
Penn West (PWE)
Let's stay in Canada and turn our focus to one of the largest players in the game. That would be none other than PWE. Penn West is one of the largest conventional oil and natural gas producers in Canada. Penn West operates a significant portfolio of opportunities with a dominant position in light oil in Canada. Based in Calgary, Alberta, Penn West operates throughout western Canada on a land base encompassing over six million acres.
As big as PWE is, it is not immune to the same issues that hit our other two companies mentioned above. Take a look at the chart below to see how well the stock price has performed over the last two years.
Obviously PWE has not been the place to be for an income investor. With such volatility over the past few years, PWE would be a tough hold for an income investor. This could all change though if energy prices make a comeback.
First let's focus on the PWE's 2012 capital program and guidance. PWE is expecting capital spending to be approximately $1.3 - $1.4 billion. Of that total, 85% of the capital is to be spent is on the company's four main light oil development projects. Once again this is a familiar theme that has run through the first three names of the article. Each company has turned their focus onto the oil side of the house business because that is where the money is. Capital expenditures for the first quarter of 2012, including net property dispositions, totaled $338 million compared to $436 million for the first quarter of 2011. The anticipated average annual production for PWE should be 168,500 - 172,500 boe/d.
The first quarter results for PWE show some very valuable pieces of information. The average production in the first quarter of 2012 was 167,420 boe per day, after the effect of approximately 4,500 boe per day of asset dispositions in January, compared to 168,801 boe per day for the fourth quarter of 2011. This means that PWE is coming in at the lower end of the range of the guidance, but is still on track. Looking a bit deeper one finds that the first quarter average liquids production was in excess of 107,000 boe per day, of which approximately 90 percent was oil. This is right where PWE wants to be as oil will be the major focus.
PWE's funds flow still shows the world that the company must operate in. The funds flow was $337 million in the first quarter of 2012 compared to $356 million in the first quarter of 2011. This was primarily due to lower natural gas prices and wider Canadian crude oil differentials offset by higher WTI oil prices.
Looking at the company's hedging activities for the first quarter we find the following.
The hedging is decent, but there is lots of potential if energy prices were to rise. PWE's plan is much like the others in the sector. They understand that energy prices will not stay depressed forever, and the time to expand is now and not later. If PWE can execute their plan, and if energy prices can rally, they will be in a much better position. Needless to say their stock price will too. Until such time, PWE yields roughly 7.7% at the time of this article.
Linn Energy (LINE)
So far in this article the companies, and their stories, have been singing the same old song. Let's change the beat and look at LINE. It is at this point that readers will now take exception to the notion that I have lumped LINE in with the other names in this article. Before we get into the reasoning as to why LINE is represented, let's take a look at them.
Linn Energy is an independent oil and natural gas company that engages in the acquisition and development of oil and gas properties. The company's properties are primarily located in the Mid-Continent, the Permian Basin, Michigan, California, and the Williston Basin in the U.S. As of December 31, 2011 the company had proved reserves of 3,370 billion cubic feet equivalent of oil and gas, and natural gas liquids, as well as operated 7,759 gross productive wells. The reserve life index is more than 21 years.
Linn Energy is a very different animal when compared to other energy names. To begin, take a look at the chart below.
Unlike the other names in this article that have plummeting stock prices, LINE's chart is rather calm in comparison. There are many different reasons for this, but it all basically falls back on LINE's management and how they run the company. Management is very risk adverse and very aware of their responsibility to the shareholders. This is shown by the current hedging program that LINE currently has in place.
For the second quarter of 2012, LINE expanded its oil and natural gas hedge positions for additional production associated with acquisitions and internal growth. When one looks at the current production estimates, LINE is approximately 100% hedged on expected natural gas production for six years through 2017. Expected oil production is 100% hedged for five years through 2016. For 2012, the company is hedged at a weighted average oil price of $97.26 per bbl and a weighted average natural gas price of $5.28 per Mcf. No other company within this article has such a vast amount of hedging in place on their production. The end result is that when price volatility enters the energy markets, LINE is more prepared for the downside. This is exactly what we see on the chart above.
LINE, during these troubling times, did not sit idly by behind their fortress of hedging. That would have been easy, but this is not management's style. LINE knows that growth is a must, and as a result the company has been on a buying spree. For example, during the second-quarter 2012 the company announced two transactions totaling approximately $1.4 billion.
The first deal for LINE came in the form of a definitive purchase agreement to acquire properties in the Jonah Field, located in southwest Wyoming. In the deal LINE acquired the asset from BP America Production Company (BP) for a contract price of $1.025 billion. A closer look at the deal shows that the acquisition is expected to produce approximately 145 million cubic feet equivalent per day of liquids-rich natural gas production. The current proved reserves total approximately 730 Bcfe, but LINE has estimated that the identified total resource potential could be approximately 1.2 Tcfe. Needless to say, LINE plans to hedge 100% of the expected net oil and natural gas production for approximately six years through 2017.
Linn's other second quarter deal was when they closed a $400 million joint-venture agreement to partner with an Anadarko affiliate in the CO2 enhanced oil recovery development in Wyoming. In the deal LINN was assigned a 23% interest in the Salt Creek field, which is expected to deliver 10 years of steady production growth while at the same time providing a low base-decline rate. Once again it seems that LINE's management is moving the company forward.
The company also has had other deals in the works as well, but let's turns our attention back to why they might be a company to own for energy's return. While the rest of the energy sector is getting battered, they have held LINE back from any major price run up. Also with the massive amount of hedging that LINE puts on, it could have negative impacts if energy prices were to spike. But currently that is not the case as the company reported gains on derivatives from oil and natural gas hedges of approximately $440 million for the quarter. This includes $304 million of noncash gains from the change in fair value of hedge positions due to a decrease in commodity prices. It also included realized hedge gains of $118 million during the second quarter.
The key is the huge amount of new assets that LINE is putting into play. Including the two most recent acquisitions mentioned above, LINE has a total of approximately $2.8 billion in acquisition and joint-venture agreements. They are broken down below:
- $1.025 billion acquisition of Jonah Field properties in the Green River Basin of Wyoming from BP
- $1.2 billion acquisition of properties in the Kansas Hugoton field from BP
- $400 million joint-venture agreement with Anadarko in the CO2 enhanced oil recovery development of the Salt Creek field in Wyoming
- $175 million acquisition of Overton Field properties in east Texas
When all is said and done LINE is going to own some premier assets. As hedging positions drop off, new positions will be added. If energy prices rebound at a later date, these new prices will be what are locked into LINE's hedging books. LINE's stock price might not take off like a rocket, but it has set itself up to be a winner for the long haul once energy prices return.
In conclusion, the above four names offer great potential once energy prices rebound. All are working hard to get new assets online despite the difficult current operating environment. As we all await energy's return, it might pay to take a second look at some of these names.