Traditionally, many income securities have come from the energy sector. Large integrated oil companies, for instance, have long been a staple of many income portfolios. A big reason for that was a business model that benefited investors: Steady demand for their product (oil) resulted in steady cash flows. Of course, the steady rise in oil prices between 2001 and 2008 didn't hurt either.
But much has changed in the past few years, as major economic trends have collided and driven oil prices lower. The emergence and economic viability of alternative energy is one such factor. The other major trend that has impacted the price of oil is the advances in hydraulic fracturing -- what most of us know as "fracking." This new technology that has unleashed huge oil and gas reserves hidden in the U.S. shale basins has resulted in massive growth in oil production.
U.S. consumers have certainly benefited from the shale boom, which lowered the price of oil and natural gas. But it has not been positive for most energy companies, largely because it also resulted in significant oversupply.
The recent sharp decline in the price of oil is a direct result of this oil glut. Just four years ago, in August 2013, West Texas Intermediate (WTI) traded at $112 per barrel. By February 2016, it was trading as low as $26 per barrel. And even though the prices have since recovered somewhat (oil prices reached a peak of $53.72 at the end of 2016), this year has not seen any further strength in oil prices. Rather the opposite -- year to date, WTI is down 8.5%.
Because lower oil prices directly threaten their profitability, the price of many oil-related equities has continued to beremained under pressure. At their peak in 2007, the energy sector accounted for about 16% of the S&P 500's total capitalization, but by 2014, total market share had dropped by almost half, to 8.5%. Today, energy stocks only represent 5.7% of the S&P 500 -- a significant decline in just 10 years.
How I'm Staying Above Oil's Decline
Subscribers to my premium newsletter, The Daily Paycheck, have largely avoided participating in the oil sector's demise because of our portfolio's limited exposure to the sector.
Our few oil-related positions have almost uniformly performed better than the rest of the energy sector, represented on the chart below by the Energy Select SPDR (NYSE: XLE).
The chart shows the one-year performance of XLE relative to the S&P 500 index and refiner Phillips 66 (NYSE: PSX), which you may remember from June of this year. As you can see, energy stocks as a group underperformed the S&P 500 index by a wide margin, while PSX outperformed its average peer to the tune of nearly 12 percentage points.
That isn't a coincidence. While Phillips 66 has suffered from changing economic conditions, it is less exposed to the price of oil than large integrated companies. The stabilization in the price of oil, moreover, should be a positive for the company.
On top of this, the company is financially strong and invests for the future, especially in its midstream business (pipelines and delivery), which is even less directly dependent on the price of oil and actually benefits from the shale activity. And the petrochemical business is actually benefitting from the lower energy prices because oil and gas are major inputs.
Moreover, shares of PSX aren't expensive, currently trading at just over 16 times expected earnings while delivering a decent dividend of $0.70 every quarter, good for a 3.3% yield. The time might come when large integrated oils' prospects improve enough (and valuations decline enough) for these stocks to become attractive. For now, though, I'm sticking with Phillips 66.
Two More Energy Stocks I'm Counting On
My portfolio also holds two promising, energy-focused master limited partnerships (MLPs). These companies aren't attractive just because of their higher yields and exposure to the midstream business [crude oil, liquefied petroleum gas (LPG) and refined products infrastructure]; they also benefit from the shale revolution. Plus, their businesses are much less dependent on the price of oil per se, as a large portion of revenue is based on the amount transported, not on the price of oil.
But this doesn't mean that all energy MLPs are created equal. The ones that were most exposed to the exploration and production business, as well as those that missed out on the shale boom, have underperformed. This probably reflects another risk that has come into play -- MLPs' high debt levels. As interest rates move higher, debt financing becomes more expensive, as do the acquisitions.
While the Alerian MLP Index (NYSE: AMLP) has declined over the past year, our two MLPs have outperformed. And I think they both are well-positioned for the future, too. Financially strong and leveraged to just the right trends, both of these companies also have attractive distribution coverage ratios (the cash available to the unitholders relative to the cash distributed). This also bodes well for future distribution increases.
Create An Income Stream That Can Survive -- No Matter What
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This article originally appeared on StreetAuthority.