Pinched by energy trusts? Consider integrated oils

by Levi Folk | November 6, 2006

If you have been pinched by the recent losses in Canadian energy trusts, consider diversifying into large-capitalization integrated oil companies. They constitute a level-headed approach to participating in one of the most promising investment themes over the next decade—offering growth prospects, income, and defensive properties related to high cash yields and low valuations.

In the interest of full disclosure, our firm, Generation Capital, has launched a principal protected note, the BMO Generation Capital Integrated Energy Protected Deposit Note, based on this large-capitalization integrated energy theme.

The main points of interest for the mainstream investor are as follows:

• Participation in the energy story that has the hallmarks of a long-term bull market.
• An income theme in consistent and growing dividends (and share repurchases).
• Less volatility relative to the energy indexes.
• Low valuations relative to the broader equity indexes.

Recent history suggests that energy prices have entered a long-term bull market created by demand pressures from China and India , now the second- and fifth-largest consumers of oil, respectively. China ’s auto market is now second to the United States in annual sales but lags in absolute size by a factor of 36. With only 12 vehicles per thousand people in China versus 774 per thousand in the U.S. , catch-up for a population that is three times as large means oil demand growth is in the cards.

The largest oil companies in North America and Europe naturally have the largest energy reserves and are monetizing oil and gas production far in excess of capital requirements. In sharp contrast to the technology bust of the 1990s, oil companies are returning cash to shareholders in the form of dividends and share repurchases. The top five oil firms are spending US$250-billion on dividends and buybacks from 2006 to 2008, according to UBS and the Financial Times. That number is likely to be higher in the final tally.

Share repurchases are a tax-efficient means of boosting shareholder value because fewer shares circulating translates to higher earnings per share and higher share prices, all else being equal. Since capital gains are taxed less than dividends (at least for high-income earners), buybacks translate to less taxation for investors on average.

In the case of Exxon Mobil Corp., CEO Rex Tillerson points out that the company’s market capitalization has increased 26% from 2000 to 2006, whereas the share price has increased 43% over the same period. The relationship between the two is attributed to Exxon’s share repurchase program that saw 12% of the float eliminated. Exxon recently announced, along with record earnings, a share buyback program equal to roughly US$8.4-billion per quarter.

The table shows the combined yield per share for dividends and share repurchases for the leading large-cap integrated oil companies. This combined figure is often referred to as shareholder yield.

*Source: Generation Capital as at September 30th, 2006

** Current year P/E ratio. Source: Thomson Financial as at Nov 03, 2006 .

A high-yield strategy is a risk-management strategy in its own right because the yield presents a floor below which a share price is supported. A sharp fall in the share price will increase the yield relative to bonds and affect its own recovery as shareholders are attracted back to the yield premium.

Indeed, this large-cap integrated energy portfolio is only 2.2% off its August highs despite the major move in the price of oil from US$77 per barrel to its current price of US$59 today. Investors bought into these stocks on weakness for the reasons mentioned above. In contrast, the S&P/TSX capped energy index is 18% off its May highs, the recent income trust story playing a part in this weakness no doubt.

Finally, valuations offer a significant discount to market multiples. The highest valued stock in the list, Exxon Mobil, sports a price-to-earnings (P/E) multiple of 11.1, which is a significant discount to the market multiple of the S&P 500. This suggests that the market expects production growth to slow or oil prices to fall ... or both.

The market had implicitly been casting this vote of non-confidence on large-cap oil over the past year but appears to be catching on in recent weeks, coming round to the bullish view as earnings and cash flow remain robust. Saudi Arabia has the capacity to create tightness in oil markets regardless of the behaviour of its OPEC peers, and with oil prices having major support at the US$55 level, these companies—as a future income and growth story—remain appealing.