Seeking Alpha

Energy CEFs Available At Large Discounts To Play An Energy Rebound

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Includes: IRR, IXC, NDP, PEO, SZC, XLE
by: Value and Income Insights
Summary

The energy sector is ready for a rebound after recent poor performance.

Energy CEFs are an interesting way to play the rebound and are available at large discounts to net asset value.

Geopolitical risks from Russia, Venezuela, and the Middle East could drive oil prices higher.

Energy was the worst-performing sector in the first quarter of 2018. The trailing one-year period was also near the bottom, beating only consumer staples.

Source: Seeking Alpha 3/29/2018

The performance of energy stocks lies in stark contrast with the performance of the underlying energy commodities. The PowerShares DB Energy ETF (NYSEARCA:DBE) is up 4.6% year to date and 25% over the last year.

Source: Seeking Alpha 3/29/2018

This has set up a scenario where energy shares may rally to catch up to the underlying price of the commodity. Furthermore, prices of energy commodities like oil and natural gas could see continued price increases due to inflation and geopolitical risks.

There is much debate about what energy prices will do in 2018. Geopolitical tensions appear to be increasing. The change of leadership in Saudi Arabia, continued conflict in Syria, and saber rattling from Russia could be triggers for price spikes in oil. Destabilization of Venezuela and the potential of leadership change in that country is another factor that could increase prices. These risk factors could continue to put a bid under the oil market.

The oil market has been propped up to some degree by the output reductions put in place by OPEC. If OPEC countries increase their output, it could hurt the oil market and put downward pressure on oil prices.

Another variable that will impact the price of energy is global economic growth. The global economy continues to strengthen led by China and the U.S. If recent market volatility is an indicator of a coming recession that would be bad news for oil and energy stocks.

Energy stocks' underperformance has improved the energy sector's attractiveness relative to the S&P 500. Using the Energy Select Sector SPDR (XLE) to represent energy stocks, we see that energy offers a higher dividend yield with lower price/book ratio than the SPDR S&P 500 Trust ETF (SPY). Forward growth expectations for the energy sector are also higher than the S&P 500. Five-year forward growth expectations for energy are 21.31% compared to growth expectations of 12.83% for the S&P 500. The forward P/E ratio for energy is higher than the S&P 500, but this is likely because of reduced earnings for energy companies due to lower price realizations.

Source: State Street Global Advisors 3/28/2018

The poor relative performance of energy stocks also impacted closed-end funds investing in energy. The funds offer attractive yields and continue to trade at wide discounts to underlying net asset values. Investors looking to add to energy holdings in 2018 would be wise to look at CEFs as a way to buy $1.00 of assets for $.90 or less. This could set up an interesting rebound if energy company earnings recover and oil prices can stabilize or move higher. Closed-end funds also offer attractive distributions. Some of the funds use options strategies to decrease risk increase distributions.

Energy stocks remain attractive long term and offer one of the better values in a stock market hitting all-time highs. Energy is also an attractive investment as most investors are naturally hedged. Energy is used to fuel their car or heat their homes. If energy prices fall, energy consumption costs will move lower, helping to offset losses in their investment portfolio. If energy prices rise, investors should see better performance in their investment portfolio to help cushion the increased cost at the pump. Gasoline prices have rebounded along with oil and now could be an attractive point to increase this hedge in investors portfolios.

Fund Analysis:

The graphic below lists several metrics that can help quickly evaluate closed-end funds including distribution, leverage, premium/discount, 1 Year Z-Statistic (from Morningstar), historic returns, and fund expense ratios. Data for XLE and the iShares Global Energy ETF (IXC) are also included to provide ETF options for investing in the same space. Data for the SPY is included to offer information for the broader market. The ETF results can also be used as a benchmark to evaluate performance.

Source: Morningstar 3/28/2018

All of the energy CEFs showed negative performance for the year to date period. There was a wide range of performance from the Voya Natural Resources Equity Income Fund (NYSE:IRR) posting the best return of -7.57% to Tortoise Energy Independence (NYSE:NDP) posting a -13.61% NAV return. All of the CEFs are trading at discounts with The Petroleum & Resources Corporation (NYSE:PEO) trading at the widest discount of 15.57%.

BlackRock Energy & Resources (NYSE:BGR) has posted the strongest results over the last 12 months. It is the only energy CEF that has a positive return over that time period. The fund is trading at a 9.28% discount to NAV, which is larger than normal and currently shows a 7.16% distribution. The distribution is helped using an option strategy. Expenses are reasonable at 1.31% and the fund is unlevered. This fund could provide interesting and relatively conservative exposure for investors looking to benefit from energy stocks.

The Cushing Renaissance Fund (NYSE:SZC) has the strongest long term performance of energy CEFs reviewed. This fund currently shows the most significant discount relative to the last year trading history based on the -2.16 Z Statistic. This metric may be a little misleading as the fund had a rights offering that will likely be dilutive to the displayed NAV. The fund takes a little different approach to energy investing. SZC is focused on companies poised to benefit from increased domestic oil production.

The fund invests in both the energy companies working to boost their production, as well as industrial companies that are expected to benefit from lower energy and feedstock costs. This is a broader way to invest in companies poised to benefit from North American shale production growth. Because of the rights offering, investors considering this fund may want to wait until the offering settles. This will allow investors to see how the additional shares being sold at a discount to NAV impacts the funds trading.

The Petroleum & Resources Corporation (NYSE:PEO) has been around since 1929 and is the oldest and probably the best known closed-end fund in the group. The fund offers the lowest expense ratio in the group. The current 15.57% discount to NAV is the widest in the group. This discount is wider than the average trading discount over the past year shown by the -1.5 Z Statistic. The long history, strong management team, and wide discount make this fund an attractive option at current levels.

The Tortoise Energy Independence Fund was the worst performing CEF both for the year to date and for the last 12-month period. NDP's focus on North American exploration and production companies investing in shale resources hurt. NDP has a relatively aggressive portfolio due to its focus on shale E&P companies. The fund uses the most leverage and has the highest distribution of 15.84%. The focus on shale E&P companies could make this fund one of the more volatile energy CEFs. Investors looking for a fund with leverage to increasing oil prices could consider this fund. Be aware that this fund would likely take biggest hit if energy weakens further.

Like BGR, the VOYA Natural Resources Equity Income Fund uses an options strategy. However, IRR's NAV performance has not impressed during the fund's life. IRR does a double digit yield at 10.89%. The fund's current discount is only 0.5% and it is trading above the one year average discount. Investors may be investing in this fund based on the distribution and lower volatility. The moderate discount and poor long term performance track record reduces the attractiveness of this fund at this time.

Conclusion:

Shares of energy companies have failed to keep up with the rise in oil prices. If oil prices stay stable or move higher energy shares could be set up for a rebound. Additionally, prices may benefit from a return of inflation. Individual investors may look to add energy sector exposure to hedge their energy use. Energy CEFs with attractive discounts and high distributions are worth consideration for investors looking to add energy exposure. PEO has a long track record with solid performance. The 15.57% discount looks attractive.

SZC also looks attractive but investors may want to wait for the dust from the recent rights offering to settle before considering an investment in this fund. It is a broader offering will benefit from domestic energy production and a continued global economic recovery. NDP is probably the riskiest of the group due to its focus on shale exploration and production companies. If investors are looking for a beta trade NDP, but beware that the fund is trading at a relatively narrow discount and the distribution may not be sustainable.

Disclosure: I am/we are long PEO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.