The year-long decline in oil prices hasn't exactly been kind to investors who have any exposure to energy in their portfolio. Even some of the most stable companies in the business have declined by more than 30%. Any investor looking at those sorts of losses is going to get nervous about their exposure to the industry. Instead of abandoning all hope, though, there are a couple of ways you can build resiliency into your portfolio of energy stocks.
We asked three of our energy contributors to highlight a segment of the energy market that can help you build a more well-rounded portfolio in the energy sector, as well as to pick a company that best represents its sector. Here's what they had to say.
Tyler Crowe: The business of oil refining is normally viewed only as a way to hedge against lower oil prices, but don't tell that to John Rockefeller. His Standard Oil empire got its start in the refining business because it was a natural bottleneck of the oil and gas value chain that gave the company immense purchasing power. Refining companies may not hold the near-monopolistic position they once did, but gaining exposure to the refining space can be a great addition to an energy portfolio.
Today, refiners that can keep their operational costs per barrel low through highly efficient operations, and by sourcing crude oil that goes for less-than-market price they can generate very high returns on capital and throw off a lot of cash for dividends. A great example of this is Northern Tier Energy (UNKNOWN:NTI.DL). While the company only owns and operates one refinery in the Minneapolis/St. Paul region, it consistently runs at a high utilization rate and a low operational cost per barrel. It is able to achieve this thanks to investments in technology that allow it to effectively source multiple types of crude oil. Also, its close proximity to oil sources in North Dakota and from Canadian oil pipelines means it normally buys oil at much lower than market price.
These elements have allowed the company to generate high returns on capital, and its variable-rate master limited partnership structure translates to a company that normally throws off a lot of cash in the form of distributions. There may not be a consistent distribution payment, but at times, those payments can be very generous, like its trailing-12-month yield of 11.5%.
Refining companies can be a great natural way to hedge your portfolio if you have other energy investments that do better when oil prices are high, but a well-run refiner can be a great investment in most price environments.
Adam Galas: One of my favorite subsectors in energy is midstream MLPs like Magellan Midstream Partners (NYSE:MMP). That's because the business model of these oil and gas pipeline, processing, and storage operators is usually based on long-term, fixed-fee contracts that result in consistent and predictable distributable cash flow, or DCF, that allows for high, secure, and growing yields.
Case in point: Magellan Midstream has rewarded investors with 13% CAGR distribution growth since 2001. Better yet, management expects to grow the payout 15% in 2015 and at least 10% in 2016, oil crisis be darned. But a high yield -- currently 4.5% based on management's 2015 projected payout -- isn't worth much if it's not safe during a commodity crash. Luckily, around 85% of Magellan's operating margin is based on fixed-fee contracts, which means that it has minimal exposure to plunging commodity prices.
For example, during the second quarter, despite oil prices crashing to 6.5-year lows, Magellan was able to grow DCF -- from which the payout is generated -- by 14%. What's more, management raised its guidance for 2015's DCF by $10 million, resulting in a full-year expected distribution coverage ratio of 1.3 -- meaning the payout is well protected from the carnage in the oil industry.