10 top funds for a 2018 gusher in energy stocks

  • By Michael Foster,
  • Kiplinger
  • – 01/09/2018
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The Northeast and the Midwest were brought to a standstill in late 2017 thanks to a nasty winter storm, followed by record-breaking cold to start the new year. Two groups have rejoiced at the wintry onslaught: schoolchildren and bulls in energy stocks.

West Texas Intermediate crude oil prices have rocketed 12% higher in the past month to near three-year highs. Spot prices for natural gas surged to a record $175 per million British thermal units at one point, Bloomberg reported – roughly 60 times the average going rate on the New York Mercantile Exchange so far this winter.

And a lot of energy stocks have enjoyed a brisk recovery after a rough first half of 2017 – itself part of a disastrous run for the sector since mid-2014.

While this could be construed as a seasonal blip in a still-bearish long-term trend, Will Rhind – CEO of commodities-focused fund provider GraniteShares – believes longer-term tailwinds will extend the trend. “While the polar vortex may have increased demand for oil at the start of the new year, the two main factors that drove oil prices higher in (late) 2017 (i.e., increased demand driven by stronger economic growth and OPEC led production cutbacks) remain influential factors for 2018,” he says.

If oil and other energy commodities really are set up for a sustainable recovery, how can retail investors participate? The answer is exchange-traded and closed-end funds that offer diversified exposure to energy stocks – and in some cases, income streams in the high single digits. Read on to learn more about 10 funds to buy to ride a rebound in oil and gas.

Data is as of Jan. 8, 2017. Yields represent the trailing 12-month yield, which is a standard measure for equity funds. Click on ticker-symbol links in each slide for current share prices and more.

ETFs for value investors

There will be an inevitable rotation to value and these ETFs are worth a look.

Energy Select Sector SPDR Fund

  • Market value: $19.6 billion
  • Dividend yield: 3.0%
  • Expenses: 0.14%

We’ll start with one of the cheapest and easiest options: the sector index fund.

The Energy Select Sector SPDR Fund (XLE) is a simple, broad sector product that holds all the energy stocks (currently 32) in the Standard & Poor’s 500-stock index (.SPX). Most of the companies are involved in energy exploration, production, transportation and/or sales, but there is a 14% weighting in firm that simply exist to service these and other energy companies. It's also weighted by market capitalization, so Exxon Mobil (XOM) and Chevron (CVX) have very outsize influence over the XLE’s performance.

At 3% currently, XLE provides a much better dividend yield than most other sectors and the S&P 500 as a whole. That payout has grown, too, by about 125% over the past decade – even including the pullback following 2014’s rout in energy prices.

The time seems ripe to jump into energy stocks, however. Prices are recovering, especially in WTI crude oil, while volatility has become more constrained.

“The price cycle at this time seems to be more constrained than previously,” Rhind says. “And while unexpected supply restrictions/disruptions can change this situation, supply reductions from OPEC cutbacks may be offset by increased production from fracking as global oil demand grows.” That, in turn, makes it easier for XLE’s oil-managing companies to manage cash flow.

SPDR S&P Oil & Gas Exploration & Production ETF

  • Market value: $2.7 billion
  • Dividend yield: 0.8%
  • Expenses: 0.35%

With a mandate to focus on companies discovering new repositories of oil and natural gas in the United States, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) gives investors growth potential more than income.

The reason for this is simple: Companies exploring new sources of oil can suddenly find their enterprise values jump as a result of newfound revenue streams from new mining and drilling operations.

SPDR’s fund sticks out from XLE and other sector and industry funds in that it’s equally weighted, meaning that at each rebalancing, every holding has the exact same potential to affect the fund’s performance. That means smaller companies such as $2 billion Carrizo Oil & Gas (CRZO) pull just as much weight as $244 billion behemoth Chevron.

If you believe commodity prices will continue to improve in 2018, XOP is a pretty direct and growth-oriented play on that trend.

ETFs for commodities rally

If inflation picks up this year, these ETFs may be worth considering.

VanEck Vectors Oil Refiners ETF

  • Market value: $14 million
  • Dividend yield: 1.2%
  • Expenses: 0.59%

The VanEck Vectors Oil Refiners ETF (CRAK) can outperform in times of strong commodity demand. Unlike XOP, however, CRAK’s portfolio earns bigger profits when demand for refined oil is increasing – which Rhind sees as likely due to greater supply pressures around the world.

“Oil’s strong performance in 2017 was mainly a result of production cutbacks by OPEC and OPEC-aligned countries, mainly Russia, and stronger than expected demand growth,” he says, adding that these trends are likely to continue in 2018.

The ultimate combination for refiners such as Phillips 66 (PSX) and Valero Energy (VLO) is low input prices (low crude oil) but high demand for refined oil. Thus, a rising-oil-price environment isn’t necessarily good for CRAK, as long as margins between crude and refined products remain high.

If 2018 is anything like 2017, CRAK will crush the market. VanEck’s refiners fund delivered a total return of 49% last year, versus a 1% loss for the XLE.

iShares U.S. Oil Equipment & Services ETF

  • Market value: $261.3 million
  • Dividend yield: 3.4%
  • Expenses: 0.44%

A beloved story among commodities traders and investment bankers is the story of the 1849 gold rush. “The ones who got rich weren’t the miners,” the story goes, “it was the guys selling the picks and shovels.”

That is the rationale behind the iShares U.S. Oil Equipment & Services ETF (IEZ) which invests in the companies selling the metaphorical picks and shovels to the companies that XLE invests in.

For instance, top IEZ holdings Schlumberger (SLB) and Halliburton (HAL) don’t actually extract any oil or gas themselves. Instead, they provide the heavy machinery and expertise that Big Oil companies need to explore for and produce energy.

That said, IEZ still is affected by oil prices. For instance, the ETF soared during the fracking boom of the early 2010s despite the Deepwater Horizon disaster that brought a lot of negative attention on the industry. But in 2014, when oil prices crashed, the fund lost nearly 23% of its value that year. And the fund is finally starting to see some life with energy prices on the rise again.

If demand for oil equipment and services continues to recover alongside oil prices in 2018, IEZ could be the sleeper energy fund of the year.

Where to invest in 2018? Read this

The bull market may be closer to its end, but it can still climb higher.

Goldman Sachs MLP Income Opportunities Fund

  • Market value: $421.5 million
  • Distribution rate: 8.8%*
  • Expenses: 1.8%

Goldman Sachs (GS) is famous for its trading desk, but many investors don’t immediately connect the dots between Goldman and energy producers. They should; the bank’s Natural Resources group has a global presence and 1,500 clients in the sector.

Goldman also has a strong closed-end fund offering in the space: The Goldman Sachs MLP Income Opportunities Fund (GMZ). Closed-end funds are somewhat like ETFs in that they trade on an exchange, but they launch with a fixed number of shares, and thus tend to trade in a close band around their net asset value.

GMZ provides investors with exposure to energy master limited partnerships (MLPs) – a tax-advantaged structure meant to spur investment in capital-intensive businesses such as energy infrastructure companies. Thus, many MLPs tend to operate oil and gas pipelines, terminals and storage facilities. Goldman’s fund holds more than 40 such companies in a top-heavy portfolio that boasts Energy Transfer Partners LP (ETP) and DCP Midstream LP (DCP) as its largest weights.

MLPs typically provide high payouts called “distributions” that typically require a complicated K-1 form, but GMZ holders get a normal 1099 and can spare themselves the tax headaches of MLP ownership. Moreover, closed-end funds typically can use debt leverage to juice returns and income distributions, and combining that with this high-income industry means an 8%-plus distribution for owners of this CEF.

Just take note that while this can lead to big outperformance in up years, it can also lead to significant downside. During MLP’s calamitous 2015, the Alerian MLP ETF (AMLP) plunged 26% … but the GMZ crashed 48%.

Kayne Anderson Energy Development Company

  • Market value: $191.0 million
  • Distribution rate: 9%
  • Expenses: 2.8%

Kayne Anderson isn’t the household name that Goldman Sachs is, but it’s still an excellent energy manager. Houston-based Kayne Anderson oversees a quartet of CEFs in the energy sector, all led by energy professionals-turned asset managers. Much of Kayne Anderson’s talent comes from the energy industry, and their close connections to America’s MLPs means they tend to know the industry much better than many of their competitors.

That has helped Kayne Anderson Energy Development Company (KED) – which is 84% invested in midstream MLPs, with 14% exposure to other midstream companies, and a small 2% in shipping MLPs – outperform in the past. Since 2011, KED has beaten the AMLP in all but one year. That includes 2017, though it still was a rough go for KED, which lost 2% of its value and had to decrease its distribution in the first half of the year.

The Republicans’ tax overhaul should do wonders for the MLP space, which is why KED’s assets jumped by more than 5% in value since the new tax law was passed. Per a December release from Kayne Anderson: “As of December 22, 2017, the Company’s net asset value per share was $17.87, which included an increase of $0.98 (5.8%) as a result of the enactment of the Tax Reform Bill today.”

However, while KED’s discount has thinned from a 2017 high of 8.3% to just 5% today, that’s still a much steeper discount than its three-year average of below 2%. And while you wait for the fund to rebound, you can collect a 9% distribution.

ESG funds with solid returns

Consider these highly rated candidates for your portfolio.

Kayne Anderson Energy Total Return Fund

  • Market value: $387.1 million
  • Distribution rate: 9.5%
  • Expenses: 1.8%

Kayne Anderson Energy Total Return Fund (KYE) is much broader in scope than the KED. The KYE is a blend of MLPs and MLP affiliates (38%) as well as midstream companies (29%), but also a healthy 22% weighting in marine companies, 3% in other energy equities and even 8% in energy-related debt.

This is a more conservative approach that makes KYE a bigger contrarian bet right now. KYE plunged 6.8% in 2017 on a total return basis, and its discount remained unusually low at around 8% for the last few months of last year and into 2018. That’s an aberration; throughout most of 2017, it traded at a roughly 5% discount. And in fact, except for a brief moment in 2015, KYE hasn’t sold for this cheap since 2009.

Top holdings at the moment include Enbridge Energy Management (EEQ) – a limited liability company that manages the business of master limited partnership Enbridge Energy Partners (EEP) – and energy midstream service provider Oneok (OKE).

Cohen & Steers MLP Income and Energy Opportunity Fund

  • Market value: $286.6 million
  • Distribution rate: 8.6%
  • Expenses: 2.16%

Better known for their REIT and preferred stock funds, Cohen & Steers also offers a few energy funds that punch above their weight. The market hasn’t really noticed this – at least not yet – which is why the Cohen & Steers MLP Income & Energy Opportunity Fund (MIE) trades at a 4.1% discount to NAV despite its 8.6% dividend yield and recently strong performance. In 2017, the fund beat almost all of its peers and had a 2.6% total return in one of the toughest years for MLPs on record.

One of the reasons for that edge is the fund’s diversification. Unlike many other energy funds, MIE goes beyond common stocks and invests in preferred stocks, which typically are less volatile and higher yielding than common stocks.

Cohen & Steers is well-known for its preferred stock savvy – the company’s Cohen & Steers Preferred Securities and Income Fund (CPXAX) manages $8 billion alone – and brings that skill to the energy portfolio in MIE. That helps smooth out rough rides, which is an important consideration given the past few years of tumult in the industry.

Focus on investing

More on investing strategies to help manage your portfolio.

BlackRock Resources & Commodities Strategy Trust

  • Market value: $981.2 million
  • Dividend yield: 6.2%
  • Expenses: 1.08%

If you want energy exposure but also want to hedge your bet a little, consider BlackRock Resources & Commodities Strategy Trust (BCX) – a natural commodity closed-end fund from BlackRock (BLK).

The fund’s largest sector position, at roughly 38%, is energy, led by large weights in Royal Dutch Shell (RDS/A), BP (BP) and Chevron. However, more than 31% of the fund is in mining, including Anglo-swiss multinational Glencore (GLCNF), and the remainder is invested in agriculture stocks such as nutrients and fertilizer specialist Agrium – which recently merged with Potash into a new entity called PotashCorp-Agrium. The fund also has exposure to paper producers and gold miners, among other businesses.

BCX currently trades at an 8%-plus discount to net asset value, and its 6.2% dividend yield is robust for this kind of asset mix. The distribution has significantly declined since its launch in 2011, but the fund finally grew its payout slightly in 2017, providing hope that it has found some normalcy.

Gamco Global Gold, Natural Resources & Income Trust

  • Market value: $716.6 million
  • Dividend yield: 11.3%
  • Expenses: 1.3%

Gamco Investors is a well-known asset management firm founded in 1977 by Mario Gabelli, who has become a billionaire as the company’s assets have swelled. The key to his success? Buffett-style value investing with a highly disciplined focus on company balance sheets and cash flows.

Those strategies have helped Gamco Global Gold, Natural Resources & Income Trust (GGN) outperform some commodity funds during the tough 2012-16 period.

Because the fund splits its focus on precious metals (which have lost value over the last six years) and oil (which is famously struggling to recover from its 2014 crisis), the fund has lost money over the past decade. However, GGN appears to be turning the corner and may be worth a look.

If 2018 proves to be another strong year for oil, that should lift the 40% of the fund invested in energy companies such as Exxon Mobil, Chevron and Schlumberger. But don’t leave out gold. After the yellow metal’s slide of the past few years, a weaker U.S. dollar and higher interest rates from the Federal Reserve could kickstart inflation and give gold some life. That would be a boon to its metals and mining holdings, which make up 58% of the fund and include Randgold Resources (GOLD) and Royal Gold (RGLD).

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