If you heat your home with oil or natural gas, or drive a vehicle with an internal combustion engine, you see how volatile energy prices can be every time you pay your fuel bills. That type of volatility is pervasive in the energy patch, and it has a significant impact on investor sentiment. Yet having some exposure to the energy sector can offer valuable diversification to your portfolio. Here are some ways to deal with oil's inherent ups and downs.
Let someone else make the decisions
If you're an active investor, it might sound counterintuitive, but you can hire someone else to handle subsets of your portfolio. In effect, you bring in an expert to track industries that you don't have the time or desire to monitor. Given the historical volatility in the energy space, it wouldn't be a bad plan to just throw your hands up and give the job to someone else by way of a closed-end fund, mutual fund, or exchange traded fund (ETF) focused on the energy patch. There are a huge number of options.
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On the closed-end front, you might look at Adams Natural Resources (PEO -0.89%). It was founded in 1929, so it's been around for a very long time. It has paid dividends for 85 years and the current yield is roughly 1.7%. That yield figure isn't totally accurate, though, because the target is to produce at least a 6% yield each year through dividends, return of capital, and capital gains distributions. It has hit that 6% level in each of the past five calendar years, which might entice income investors.
Closed-end funds are pooled investments similar to mutual funds, but they sell a set number of shares that trade all day on the stock exchange at prices that may be higher or lower than the portfolio's net asset value (NAV). You should try to make sure you buy when the price is at or below the NAV. Adams Natural Resources' expense ratio is a reasonable 0.64%.
On the mutual fund front, you could start your search with a fund like Fidelity Natural Resources (FNARX). The expense ratio is around 0.77%, and it has been operating since 1997. The yield is roughly 1.9%. The focus of the fund is to own "companies that own or develop natural resources, or supply goods and services to such companies." As the performance chart below shows, the fund has lagged a little behind Adams and Energy Select Sector SPDR ETF, but it is highly diversified and offered by a well-respected mutual fund family. You should be able to find similar options at Vanguard, T. Rowe Price, and other fund shops.
PEO Total Return Level data by YCharts.
Energy Select Sector SPDR ETF is a quick solution on the ETF front, as it basically owns the energy stocks that are included in the S&P 500 index. There are ETFs that get more granular and stray well beyond the largest companies, but Energy Select Sector SPDR is a good basic offering that will get you energy-sector exposure without taking on undue risk. The expense ratio is a very low 0.1%. The yield is around 3.7%. As the preceding graph highlights, this ETF has performed nearly as well as Adams Natural Resources over the past decade, looking at total return, which assumes reinvested dividends.
Making your own energy choices
If you'd rather cherry-pick your own energy exposure, you need to step back and think about the big picture. The natural resources industry can be broken down into the upstream (drilling), midstream (pipelines), and downstream (chemicals and refining) segments. Of these groups, the investment options least exposed to energy prices are likely to be found in the midstream, like master limited partnership (MLP) Enterprise Products Partners (EPD 0.45%).
Enterprise owns a massive portfolio of energy pipelines, storage, transportation, and processing assets. Like many midstream companies, it charges fees for the use of those assets. The prices of the commodities that run through its infrastructure system aren't as important as the volume that flows through it. Demand for Enterprise's assets tends to remain robust in both good energy markets and bad, providing fairly consistent cash flows over time to support the hefty 7.5% distribution yield. Notably, the distribution has been increased annually for 25 consecutive years. If you're a conservative income investor, Enterprise, or another midstream company, could be a good option for you.
The stocks most exposed to oil prices will be drillers -- the upstream -- like Devon Energy (DVN 0.19%). This company is a U.S.-focused exploration and production company that has tied its dividend to performance. So when energy prices are high, and the company is doing well, investors will benefit from larger dividends. When energy prices are weak, the dividend will probably end up getting cut. It may not be the best option for all investors, but the variable dividend would probably mean you collect more in dividend payments just as you're facing higher costs for heating your home and filling your car's tank. Although the yield today is 8.4%, given the nature of the variable dividend, you really can't place too much value on that figure.
The downstream is more complex, because there are two sides to consider. Energy prices directly affect the costs a company like Valero Energy (VLO -0.80%) pays for the inputs into its refineries, but the refiner also has to deal with supply and demand dynamics for the products it produces, like gasoline. The stock has performed quite well over the past decade, but the ups and downs have been fairly extreme.
If you're looking for direct energy exposure, it might be better to avoid this niche of the energy patch. But you could consider an integrated energy giant like ExxonMobil (XOM -2.78%), which owns assets across the entire energy value chain, from the upstream, through the midstream, and into the downstream.
DVN Total Return Level data by YCharts.
With a $440 billion market cap, Exxon is a global energy giant and could easily be the only energy stock you own, given the broad exposure it has to the sector. One feature that separates Exxon from Devon is that Exxon has long focused on providing a regular and growing dividend to shareholders. The yield is around 3.4% today, and management has been annually increasing the dividend for over four decades.
The general idea of the business is that oil prices will have the largest impact on the company's performance, but the exposure to the midstream and downstream, which can benefit when oil prices are low, will help soften the industry's inherent ups and downs. For more conservative types, it would probably be a better fit than Devon Energy, but maybe not quite as attractive as Enterprise if you're looking to maximize the income your portfolio generates.
How much work do you want to put in?
All of the investment options listed here are meant to be examples to show just how expansive your options are in the energy sector. If you like investing and enjoy putting in the time to get to know individual companies, Enterprise, Devon, and Exxon are all great starting points. However, the key is that they offer very different ways to put your money to work in energy stocks.
For some, the work needed to understand and track the energy sector, and the stocks within it, may not be worth it. In that case, you may want to let someone else do the heavy lifting, with a closed-end fund like Adams Natural Resources, a mutual fund like Fidelity Natural Resources, or an ETF like Energy Select Sector SPDR ETF each good options to examine. In all, even though oil prices are volatile, you can still find a way to add some exposure to your portfolio if you think through your big-picture investment plan.