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CALGARY (GlobeinvestorGOLD) — While the most common view is that crude oil prices will trend lower over the coming months, the most common view has been largely wrong for the past couple of years. How can an investor have energy investments and still have defend against weak crude oil prices? It's almost impossible but, there are stock holdings that give you a chance at reducing volatility: Units of energy infrastructure trusts.
There are two major influences that must be dealt with when building a defence. The first is the idea that when the tide goes out, all boats go down. Simply put, when crude prices drop, momentum investors sell, led by the most liquid energy stocks in terms of volume of trading, but bid prices fall rapidly for all stocks, especially illiquid names.
Thus, shares in energy production companies, in general, have poor defences against weak prices, even if they already trade at low price multiples. Canada's integrated oil companies are only slightly better off, as they derive 80 per cent or more of their income from production activity. However, infrastructure trusts have a very stable source of revenue and earnings, despite energy commodity price volatility.
The second influence is that — within a substantial range of crude oil prices — over the short term, industry investment on exploration and development won't change. The oil industry plans its capital spending over a fiscal year or more, and companies are reluctant to change course based on (perceived ) short term price swings.
Thus, the run up in crude prices from the low $30 (U.S.) range to over $40 had no impact on industry spending intentions, and a return to $30 will, likewise, have no impact. Also, budgeted cash flow and earnings, based on moderate prices, will not change. This means that industry spending on infrastructure (gathering, processing, and transportation) remains relatively stable, despite the crude price volatility.
Energy infrastructure trusts, which include Enbridge Income Fund, Inter Pipeline, Keyspan Facilities Income Fund and Taylor Gas Liquids Fund, are not revenue-sensitive to crude oil and natural gas prices. In fact, their balance sheets tend to be so low in debt leverage, that their revenues have little sensitivity to interest rates. Nevertheless, their unit prices are sensitive to movements in interest rates. Only after a period of sustained low crude oil prices might low drilling rig activity affect production levels, and thus revenue from gathering, processing, and transportation.
One can even argue that infrastructure trusts have a built-in benefit from lower energy commodity prices. In a low price environment, production companies will seek alternative forms of capital, instead of selling equity at low stock prices and raising their debt leverage. It is generally accepted that infrastructure assets are given little value in a production companies, compared to the valuation of reserves or production.
On the other hand, infrastructure trusts achieve relatively lofty valuations. As you assess your gains in energy stocks and the risk of lower crude oil prices, look to infrastructure trusts as a way to mitigate the risk of falling crude oil prices.
Wilf Gobert is a managing Director for Peters & Co., a Calgary-based full-service investment dealer.