How to Create a Balanced Investment in Energy

by: Lee Eugene Munson, CFA

Co-written by Lorraine Ell

The energy sector has a role in any portfolio. At Portfolio Asset Management, since the majority of our clients are retired and cash flow oriented, an investment in energy needed to balance appreciation with a stream of income. Our strategy was to combine high yielding, publicly traded LP and LLC, with an integrated oil company, and a raw commodity ETN.

A few months ago we started building a position in Linn Energy, LLC (LINE). At the time it was hit by apparent selling pressure from Lehman that owned 13% of the float and by the general panic concerning energy prices. We liked the fact that it was a Limited Liability Company (LLC) that paid a good return with a heavy weighting on mature fields. LINE had sold off some of the more speculative properties, but, as we discovered during a conference call, the company was fully hedged on its production through 2011. So, if you don’t want to make a call on the price of energy, which we didn’t at the time, you could stay agnostic and pick up some yield.

Recently, we added BreitBurn Energy Partners (BBEP) for similar reasons, but it is only 70-80% hedged on production. This leaves a little room on the upside, and we want that going forward. In addition, management was happy to stop buying up new fields, simply sitting on current production. Perhaps not the most exciting play, but still a good move for this environment.

Now that we have a few high yielding cash flow securities, we decided to add some stable, integrated oil into the mix. We are simply long British Petroleum (NYSE:BP). Nothing earth shattering here, but the 8+% dividend provides some protection that the stock will not sink to nothing. Exxon (NYSE:XOM) is exposed with its small dividend. We also like that Tony Hayward is trying to turn around the firm after taking over as CEO in January of 2007.

Now that we have the cash flow, some upside on energy prices, and a strong blue chip, let’s get down to the raw commodity itself. We use OIL, an exchange traded note from Barclays. The strategy involves rolling 30-day futures contracts on West Texas Intermediate (WTI) plus treasuries. Don’t get excited, the treasury roll is based on the three-month treasury, which is basically zero. Every five business days the manager rolls 20% of the contracts.

While simple, there are some issues. First, this is really the spot price of WTI, which can be different from what you see in the paper or on TV. Those prices are usually contracts that go out a few months, but the media rarely tells you this. In addition, there is some debate on WTI versus Brent as the true benchmark. The bottom line is that it doesn’t matter as long as we are consistent and long term in our thinking. We are not trying to trade OIL here, but instead are making a bet that over the next few years the spot price will head above 60. This would give us an incredible return of 10-25% or more. The catch? Black gold could stay in the 30’s for years or go lower and OIL does not pay a dividend. This is why we added the other three securities to pump up some yield.

When you add it up, you can use each security in equal weights, capture around a 12% yield, and let it ride. While we like to trade BP, our preference (never say never) is to let the other three do their job and leave them alone. In this market, there is little out there we can say that about.

Disclosure: Long BBEP, LINE, BP, OIL.