Hey folks. I’ve been meaning to write a piece on the future of oil for a while, but Gladys, the lady who reads the crystal ball, has been out of town.

 

Remember in 2005 when analysts were all talking about the planet reaching “peak oil”? Well, fast forward to 2016. Now, we have an oversupply. Nobody saw that one coming except Gladys, of course.

 

So, I’ll just stick to writing about things I know. The uncomplicated and rational reasons I used for taking the plunge and investing in oil stocks.

 

The first reason’s a biggie.

 

No:1  Growing Demand for Oil will Benefit a Long Term Investment Portfolio

As a bit of background. I’m presently holding iShares S&P/TSX Capped Energy Index Fund (Ticker: XEG.TO).

 

 

This exchange traded fund (ETF) consists of securities within the Canadian energy sector that are listed on the Toronto Stock Exchange (TSX). Giant and large cap companies constitute over 50% of this ETF.

 

XEG has been on fire, rallying +15% over the last 4 weeks, but it is still 48% off its high water mark. In comparison, the S&P Energy Index has gained +11% over the same time frame.

 

 

Global Growth Requires More Energy

As an investor in energy, I work with the simple assumption that the world will need more and more energy. While that assumption still holds true, the cost of that energy, in the form of oil, has come down dramatically and has changed the dynamics of other forms of energy along the way.

 

Oil, however, is still the most reliable source of energy we have, with benefits other energy sources lack. Global economic growth will inevitably put pressure on oil supplies in the medium to long term.

 

Global_oil_consumption_1980-2013

 

But why invest in Canadian crude production?

 

Canada’s Stable and Growing Customer Base for Oil

To start. Canada has the third largest reserves of oil and is the world’s leading exporter of oil to the U.S. According to Canada’s Ministry of Natural Resources, Canada is the 5th largest supplier of crude oil with just over 53% of all production being exported to the United States. Canada has become a crucial part of U.S. energy policy in the push towards energy independence.

 

Besides having a reliable customer in the form of U.S. importers, oil is an international commodity. As a result, Canadian producers have the ability to export to a broader, more diverse and expanding customer base. Notably, demand in China and India is expected to grow. These two countries alone represent over a third of the global population, however account for about 12% of global oil consumption.

 

Demand for Canadian oil is growing.

 

My intentions are pretty straight forward with expectations that are simple and realistic. Augment my returns from energy companies over time as demand for their oil production expands.

 

No:2  Fire Up Returns of a Diversified Portfolio from Sector Concentration

Diversification is a central part of my portfolio strategy. I already hold individual senior and intermediate energy companies as part of a diversified portfolio. XEG’s role is to increase returns of the energy component of my portfolio by increasing its weight.

 

The industry is driven by demand during specific segments of the global economic cycles. The volatility in crude prices can radically affect the share prices of companies within the industry and any ETF which hold them as an underlying security. The energy sector, being un-loved by investors these days, has resulted in XEG being sold at a discount.

 

Large Cap Companies’ Holdings Supercharge XEG

Of course, by purchasing XEG, sector concentration portfolio risk, among others, increases. To balance off some of that risk, I purchased XEG with less than 2% of my portfolio, that portion of my portfolio directed at more speculative and risky investments.

 

Other forms of risk, stemming from the quality of the underlying companies, are mitigated as the 2 top holdings within the ETF are the largest oil companies in Canada. These two companies constitute over 45% of the holdings of XEG.

 

The two companies in question, are Suncor and Canadian Oil Sands. Recently, a Suncor $4.2 billion bid for assets of Canadian Oil sands was accepted. Oil industry consolidation due to excess supply is expected to continue until crude prices stabilize. Rationalization among the large cap companies should boost shareholder returns in the long term.

 

As the share prices within the energy sector normalize and appreciate, the increased sectorial concentration, within my portfolio, will add to the overall returns.

 

No:3  Rebounding Crude Prices will Improve Portfolio Returns

As I noted before. Crude is a volatile commodity. Oil prices change quickly. An attempt at timing the inevitable oil correction is crazy, however, spending time in the market is the right way forward. In purchasing XEG I will take advantage of any price reversion to the norm and my long term investing horizon.

 

Without trying to call the bottom, I need an idea of where prices are going.

 

A Low Point in the Past 20-Year History of Oil Market Volatility

It sort of looks like prices are generally going up from here.

 

The recent Oil Market Report from the International Energy Agency (IEA) has indicated that demand is expected to be unchanged for 2016, at 1.6 mb/d. Output, the organization says, remains unchanged primarily as OPEC attempts to hold onto marketshare, however prices may have reached a bottom.

 

Within the last 15 years crude has been highly volatile. It’s almost mind numbing to think that the benchmark Brent crude dropped from a high of $145/bbl in 2008 and is now trading around $41.

 

Technological Innovation is Drastically Reducing the Costs of Production

Canada, along with Saudi Arabia, the United States, Iraq and Iran are one of the largest sources of marginal production with the capacity to rapidly increase production as the demand is required. The marginal costs for Canadian production is $41/barrel. By comparison, U.S. shale costs are around $36/barrel. On average, the wellhead breakeven price has dropped by more than 40% between 2013 and 2015.

 

Rystad Energy is an oil and gas consulting service, which has information from roughly 65,000 oil and gas fields around the world. Their studies show that technology is coming into play to further reduce production costs.

 

NASWell_breakeven_07mar2016

 

Crude prices have driven the stock market over the past several months. That linkage will inevitably break down. Crude prices will recover over time and markets as well. With production elasticity in mind, Canada is expected to profit from rising crude prices. Especially as prices move above the $40 level.

 

Brent crude gained +20% over the past 4 weeks. Already recovering by over 42% from its January lows. XEG has made corresponding moves, with double digit gains, tracking the price of crude.

 

As both crude prices and the stock market improve, XEG is gaining in value.

 

No:4  Investing in Politically Stabile Countries have Less Portfolio Risks

Canadians are not revolutionaries. Despite what I may think of the different political parties in Canada, there is very little portfolio risk regarding a change in the country’s government.

 

In 2015, for example, a new federal government was elected. The new Prime Minister, Justin Trudeau, has a number of energy policy initiatives he would like to enact. While the new initiatives are a change from the previous Prime Minister’s, the investment environment still remains accommodative.

 

Canada is also a developed market with a relatively high level of economic growth and security. The country has none of the additional risks involved with investing in an emerging or frontier market. That’s a big check mark in the plus column for me.

 

Geopolitical risks, however, are prevalent in the majority of oil producing countries. As a value investor, I have to be conscious and concerned with the possible instability in the country in which I have investments. These risks may affect the returns on my investment or may even affect the ability to withdraw all or some of the capital of the investment.

 

Risk Premium is Low for Canada

In many of the 10 top oil producing countries there are authoritative and corrupt governments and/ or “unpleasant” military situations.

 

Brazil being the current poster child for political interference, kickbacks and corruption in the country’s oil industry.

 

Presently, Brazil’s ruling political party, led by President Delma Rousseff, is deeply embroiled in a corruption scandal. The state run oil company, Petrobras, is at the centre of the widening crisis. Her Presidency may not last the next 3 months as there are wide spread public demonstrations. The Brazilian Congress has also begun impeachment hearings against the President.

 

Russia is another example of unnecessary political risks in a portfolio. Here there has been evidence of the Head of State leading or sanctioning the expropriation of investments and disregarding minority shareholders’ rights.

 

But the Russian Federation and Brazil are not alone in injecting political risk into any oil industry investment. On that same list of the big ten oil producing countries is Iran, Saudi Arabia, Iraq, China and Kuwait. I will not trust my investments in the hands of the policy makers in those countries.

 

XEG is 100% Canadian. Geopolitical uncertainty is removed from my calculations by investing in Canada.

 

No:5  Increasing Dividend Yields Makes for a Very Attractive Investment

This one’s a no-brainer.

 

With the drop in market cap, dividends of solid energy companies have increased. XEG has a 3.76% 12-month yield.

 

Granted, oil companies are coming under pressure to cut their dividends as their revenues have dropped. Within the ETF, Crescent Point Energy, for one, has cut its dividend by 70%, but started with yields sometimes as high as 15%. Other companies, like Suncor, have been reassuring shareholders that their dividend is secure.

 

XEG, being an ETF, has a dividend which is secured over the 43 constituent companies. It is therefore likely that the XEG dividend will remain in some form.

 

A dividend is one more reason why I bought XEG.

 

Conclusion

Countries have been known to manipulate their oil statistics to their advantage. All that to say that I’ve encountered a lot of contradictory information regarding oil supply and demand. This only serves to increase the risk level of this type of investment.

 

As a value investor with a long term investment horizon, I bought XEG when it was, not surprisingly, well off its 52 week high of $15.48. It’s presently trading below levels last seen in the aftermath of the 2009 financial crisis. Over the past 4 weeks XEG has moved from $9.60 to $11.16.

 

I can be quite tactical. Meaning that, when investing in stocks, I have never stuck dogmatically to buying and holding forever. If I reach a certain level of comfort or discomfort with the returns of XEG I will sell it or at least trim my position. I did not buy XEG at the bottom, so sadly, I’m not in the position to take full advantage of the 4-week +15% gain.

 

I see a lot of upside potential which significantly exceeds downside risk. The potential for price appreciation make this a purchase typical of my value investing philosophy.

 

I look forward to your feedback. Please write in with your comments and share:  Facebook.    Google+.    LinkedIn.    Twitter.

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