The collapse in oil prices over the past year caught almost everyone by surprise. While some thought oil might pull back a bit as a result of slowing global economic growth, no one foresaw the drastic moves undertaken by the Saudis and certain other members of OPEC. The conventional policy was for the Saudis to protect price and cut production when prices began to decline. Instead, they decided to protect market share and committed to pump oil regardless of price. This move was designed to put pressure on the North America unconventional oil and gas producers who were increasingly taking market shares from OPEC producers. The resulting flood of oil coming to market is a major reason crude prices have fallen more than 50% over the past year.
This decline in oil prices has been reflected in the prices of energy and oil services stocks as well. Master limited partnerships (MLPs) that own energy-related assets have also seen their stock prices plunge in price. Even the huge blue chip integrated oils like Exxon Mobil Corp. (XOM) and Chevron Corporation (CVX) have seen significant declines in their stock price. Many pundits have suggested that this decline represents an extraordinary long-term buying opportunity.
The problem with buying energy-related issues right now is that there is no way of knowing what oil will do in the short-term. David Rubenstein of private equity giant The Carlyle Group (CG) has suggested that oil is the best investment in the world, but he also said that it could well go down more before it goes higher. Investors need to have a great deal of patience and a stomach for volatility to step into oil stocks today.
Global economics and demographics would suggest a long-term recovery in the energy sector is inevitable at some point, and those looking to invest in it would do well to be guided by the advice of legendary value investor Seth Klarman of Baupost Group. In his 2009 shareholder letter he wrote, “While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed.” He added later in the note to investors that “an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”
In addition to not trying to time the market, investors might want to consider using a closed-end mutual fund to buy the depressed energy stocks at a double bargain price. Closed-end funds issue a set number of shares and can often trade at a deep discount to the value of the underlying stocks. Unlike open-end mutual funds which issue and redeem shares as needed on a daily basis, closed-end funds trade on the major exchanges like regular stocks and are therefore subject to the same emotional and psychological biases of individual stocks.
Adams Natural Resources Fund (PEO) is a great example of a closed-end fund that allows you to buy beaten up energy stocks at an additional discount. The fund is the oldest energy and natural resources-focused closed-end funds in the United States. The fund was originally known as Petroleum & Resources Corporation and was originally listed back in January of 1929.The fund was renamed in March of 2015 to reflect its relations with other Adams closed-end funds.
Adams Natural Resources invests in energy and basic materials companies, with a heavy emphasis on energy stocks. The portfolio today is 77% invested in energy stocks. The top five holding make up more than 42% of the total portfolio. All five are energy-related blue chips:
Exxon Mobil Corp (XOM) 15.66%
Chevron Corp (CVX) 9.93%
Schlumberger NV (SLB) 7.47%
Phillips 66 (PSX) 4.81%
Occidental Petroleum Corp (OXY) 4.36%
The fund is currently trading at a 15.53% discount of the net asset value of its actual holdings, so you are buying these energy and oil services blue chips at 84.47% of the last closing price. The fund has managed distribution policy that mandates a 6% annual distribution rate, or more, for the foreseeable future in both up and down markets, so you are collecting a stream of cash flow while waiting for oil prices to rebound. Using a dividend reinvestment plan, you can plow the cash right back into discounted portfolio of energy-related stocks while they are at bargains levels.
Kayne Anderson Energy Total Return Fund (KYE) is another solid choice for investors to buy energy assets at a discount to their current market value. The fund invests in a range of energy-related investments, including energy-related master limited partnerships (MLPs), midstream corporations, marine transportation, energy-related debt and Canadian income trusts. Three of the top five holding are companies that deal with midstream assets and energy infrastructure like pipelines, transportation and storage facilities for oil and gas companies. The remaining companies are a tanker company that transports crude oil, and one that refines oil products as well as chemicals. The top five comprise 50.47% of the total portfolio. They are:
Enbridge Energy Management (EEQ) 18.27%
Kinder Morgan Inc. (KMI) 17.77%
Capital Product Partners LP (CPLP) 5.49%
Williams Companies Inc. (WMB) 4.84%
Plains All American Pipeline LP (PAA) 4.57%
The fund is currently trading at a discount of 14.03% to the value of the underlying portfolio. The current distribution yield is 12%, and investors would be best suited by reinvesting back into shares of the fund at the current prices of the shares. When energy does eventually rebound, the assets owned by the Kayne Anderson Energy Total Returns Fund should increase in value.
The Bottom Line
Predicting oil prices in the short run is difficult at best. Patient investors should eventually see a rise in oil and gas prices as the world economy recovers at some point in the future and as demand once again surpasses supply. Using close-end funds purchased at a discount to the current value of the holdings may give patient investors an additional source of profit when oil stocks return and the discount narrows.
Disclosure: As of the time of this writing, the author holds no shares in any of the funds mentioned.