Powering Up Your Portfolio With Energy

May 5, 2017 Craig Maddock

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    The size, dynamism and economic centrality of the energy sector, especially in Canada, mean it shouldn’t be ignored by most investors. Energy can play a big role in powering portfolio returns.

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    The energy sector is complex, highly regulated, and home to start-ups and giant state-owned enterprises.      

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    It is moving toward a green future and includes some of the world’s most innovative companies.   

Every time I gas up my car, pay my home heating bill or read about politicians sparring over carbon taxes, I’m reminded how important energy is to our daily lives and to our lives as investors. We use energy every day in so many ways, and it plays a central role in Canada’s economy. But this familiarity doesn’t make it a straightforward investment proposition.

It’s easy to think of energy as an input that powers things—but the energy sector is so much more. It offers opportunities to invest in exploration, extraction, production, distribution, renewables, even services. The energy sector is complex, highly regulated, and home to start-ups and giant state-owned enterprises. In some countries, like Saudi Arabia, governments are directly involved; other countries, like the United States, have no state‑owned energy companies. All governments are keen to tax energy companies, and members of the Organization of Petroleum Exporting Countries (OPEC) fix prices.

With so much diversity on display, how does an investor identify the key risks and opportunities? First of all, we need to remember that the energy sector is full of cyclical companies whose share prices rise and fall along with the ebbs and flows of the global economy. Canadians saw this first-hand as oil tumbled from US$128 a barrel in 2008 to below US$30 barrel in 2016, taking energy shares lower across the board and changing the face of Canada’s resource sector.

A global sector that does not heed borders

Another key characteristic of the energy sector is its global nature. Limiting your exposure to Canada, for example, doesn’t mean you are insulated from what happens elsewhere. The International Energy Agency estimates that worldwide investment in the sector hit US$1.8 trillion in 2015.

These investments criss-cross borders all the time. In March, Canadian Natural Resources made a $12.74‑billion deal to buy Alberta oil sands assets from Royal Dutch Shell and Marathon Oil. Meanwhile, we continue to hear talk of an initial public offering from Saudi Arabia’s state-owned Aramco, which could be the world’s biggest IPO to date. Analysts have pegged the value of the IPO at anywhere from US$400 billion to US$2 trillion. These kinds of numbers move markets around the world.

The energy sector includes some of the world's most innovative companies, many of which are working to radically alter how we produce and consume energy. Green energy companies are trying to solve problems such as how to store the world's abundant supply of solar energy and how to make liquid fuels from hydrogen produced by the electrolysis of water. However, many of these emerging technologies tend to be more volatile and speculative investments, making them unsuitable for some investors.

A fossil-fuel-free investment alternative

In 2015, members of the Canadian Medical Association told MD Financial Management that they were interested in opportunities to invest in renewable energy. That's why we created the MD Fossil Fuel Free Equity Fund™ and the MD Fossil Fuel Free Bond Fund™. 

Most fossil-fuel-free funds available in Canada eliminate only companies involved in fossil fuel extraction. MD Fossil Fuel Free Funds™ go a step further by also avoiding companies involved in processing or transporting these fuels.

 

Three ways to approach investing in energy

 

 

 

My team and I see three ways of investing in energy companies. You can invest in energy producers, you can invest in energy services providers, or you can buy the debt of either of these kinds of companies.

 

 

 

1. Investing in energy producers

 

 

 

Enbridge is an example of an energy producer that we hold in MD Balanced Fund, MD Dividend Income Fund, MD Equity Fund, MD Select Fund and MDPIM Canadian Equity Pool. Enbridge is Canada’s largest natural gas distribution company; it also has major oil sands projects and is one of Canada’s largest renewable-energy generators. I recently spoke with Aly Alladina, a portfolio manager at PCJ Investment Counsel, which advises MD Select Fund and MDPIM Canadian Equity Pool. He had some interesting things to say about Enbridge.

 

 

 

According to Aly, Enbridge is interesting because it has a relatively low-volatility profile. The company has limited direct exposure to commodity prices, in part due to long-term commercial agreements called “take or pay” contracts. Enbridge customers sign these agreements, guaranteeing they will pay a set amount for a set amount of gas or pay a penalty.

 

 

 

Aly emphasizes that this shift to a take-or-pay model is significant. Historically, pipelines have been rate‑sensitive businesses. Rising interest rates can hurt stocks in Canadian energy infrastructure, like pipelines, as rising rates can increase debt levels in what is a capital-intensive industry. This would prompt income-seeking investors to move into the bond markets. But now, Aly explains, take-or-pay contracts have shifted companies like Enbridge from an income orientation to a growth orientation where returns are largely driven by the market.

 

 

 

Aly also called Enbridge’s February acquisition of Spectra Energy, a U.S. natural gas giant, “transformative.” The takeover creates the largest energy infrastructure company in North America, with a value of about $166 billion, an inventory of current and potential growth projects worth $75 and anticipated annual dividend growth of 10–12% through 2024.

 

 

 

2. Investing in energy services companies

 

 

 

The second big group of energy companies we consider includes those that deliver energy to end-users like consumers. Hydro One fits this description perfectly. We hold it in MD Dividend Growth Fund, MD Dividend Income Fund and MDPIM Dividend Pool.

 

 

 

Ontario’s electricity provider is one of North America’s largest electricity delivery companies based on geographic scope and asset value. Its core businesses earn stable, regulated returns and accounted for almost all of the $721 million in net income it earned in 2016. Hydro One has also offered a higher yield than the 30‑year Government of Canada bond since 2008.

 

 

 

Like Enbridge, Hydro One comes without any real commodity price risk because it is just transmitting energy to customers. But, as a monopolistic entity that is 70% owned by the Government of Ontario, it’s hard to evaluate. This can also make it a political hot button: Premier Kathleen Wynne’s government knows this all too well as they work to allay voters’ ire over the price of electricity in Ontario.

 

 

 

One way to evaluate Hydro One is to come up with other companies to compare it against. Marc Natal, vice-president of client servicing at our asset manager Montrusco Bolton, which advises MD Dividend Growth Fund and MDPIM Dividend Pool, likes to compare Hydro One to Fortis and Emera Energy.

 

 

 

Fortis is an international, diversified electric utility holding company based in St. John’s. It operates in Canada, the United States, Central America and the Caribbean. Emera Energy is an energy services company that provides innovative and customized marketing, trading and asset management services in northeastern North America.

 

 

 

Montrusco Bolton uses traditional metrics like the enterprise value multiple to evaluate Hydro One against alternatives like Fortis and Emera. In simple terms, this shows how long it would take for an acquisition to earn enough to pay for itself, assuming there is no change in a company’s earnings before interest, taxes, depreciation and amortization (EBITDA).This allows Montrusco Bolton to view Hydro One the same way a potential buyer would.

 

 

 

3. Buying the debt of energy companies

 

 

 

Energy companies are very capital-intensive, so there are plenty of opportunities to own the debt they issue to fund big projects and acquisitions.

 

 

 

Our analysis shows that pipelines are leading issuers of bonds in 2017, as there are growing signs that the energy industry is recovering. Yields on debt issued in the energy sector have decreased significantly compared to government bonds. MD portfolios were well positioned before this decrease, allowing us to take advantage of rising prices as yields fell on some attractive debt issues.

 

 

 

The evolving energy sector is always presenting new opportunities

 

 

 

The size, dynamism and economic centrality of the energy sector, especially in Canada, mean it shouldn’t be ignored by most investors. From traditional producers to emerging players in green energy, this sector can play a big role in powering portfolio returns.

About the Author

Craig Maddock

CRAIG MADDOCK, CFP, CFA, CIM, MBA, is Vice President with the Investment Management team at MD Financial Management. He leads the team of portfolio managers and investment analysts responsible for managing the firm’s mutual funds and investment pools.

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