When amassing a basket of exchange trade funds designed to capture consistent returns in Canada, the first sector to consider is Energy.
Rather than just buying an index like the S&P/TSX 60, which is heavily tied to a shortlist of holdings, take the time to target ETFs that individually offer depth and collectively offer breadth, when owned in conjunction with an S&P/TSX 60 or Composite fund.
The energy industry is in the midst of overcoming challenges, namely the deep discount Canadian producers in the West receive on their oil versus the reference crude price. For long-term investors, this presents an opportunity to buy in at a relatively inexpensive point.
The primary problem is limited access to pipelines that connect western Canada's producers to their end markets: Keystone XL pipeline continue to make headlines, but once a solution is found it could result in billions of dollars being recouped by producers, and that implies an enticing upside.
Industry experts estimate the infrastructure expansion required to ease the backlog will take 12 to 18 months, with a proposal by TransCanada to convert a cross-country gas pipeline, which would create access to the Eastern seaboard, gaining traction in recent days. In the meantime, producers have scaled back expansion, emphasizing a newfound focus on profitability – a response that should protect net income from further declines, possibly putting a floor under their stock prices.
The iShares S&P/TSX Capped Energy Index Fund
The most effective way to invest in the energy sector to position for an unwinding of the western Canada discount is by going long XEG. Its largest holding is Suncor Energy (18.5 per cent). In November, Suncor posted very healthy third-quarter numbers, and in September, the company renewed its share buyback plan, indicating that the stock is undervalued and will receive considerable support at current levels. The company trades at a trailing Price/Earnings multiple of 11.2x and a trailing Price/Sales multiple of 1.3x. Both metrics should instill confidence that the company's fundamentals more than adequately support its current valuation. The stock price peaked right before the financial crisis, touching $70 per share in May 2008. It has bounced around between $25 and $40 per share since, with a few highs and lows outside of this range, but it has yet to fully recover from the downturn, suggesting a further rally could be in the stock's future. The next big market event will be its 2012 full year earnings announcement scheduled for February 5th, 2013, which could create some positive price momentum.
The next biggest holdings are Canadian Natural Resources (11.9 per cent) and Cenovus Energy (8.9 per cent). Both companies face similar challenges to Suncor, and would directly benefit from a solution to the pipeline shortage.
Overall the S&P/TSX Capped Energy Index Fund is well-designed with a portfolio of fifty names and overall assets of over $800-million. The fund was launched in March 2001 and has steadily appreciated over its eleven-year history, currently up almost 200 per cent since inception. Its dividend yield of 1.5 per cent more than covers the fund's management fee of 0.55 per cent.
BMO S&P/TSX Equal Weight Oil & Gas Index ETF
The biggest holding in this fund is Canadian Oil Sands (7.1 per cent). In 2012, the company announced that its cash position was shrinking while debt levels were rising at an accelerated pace. Given the firm's aggressive capital expenditure program and dividend commitment, this is not an encouraging trend. Further complicating Canadian Oil Sands' prospects was a research report released in July 2012 by a Bank of America Merrill Lynch analyst that warned that high production costs, specifically at Syncrude, would require oil prices of $113 per barrel to provide enough cash flow for the firm to break-even. Applying an equal weight approach spreads the risk across the portfolio, however with only sixteen holdings, ZEO is arguably more concentrated than XEG and could be seen as riskier. That said, the inclusion of Pipeline Companies, namely Enbridge and TransCanada, could lower overall risk.
iShares Oil Sands Index Fund
Similar to XEG, the top holding in this ETF is Suncor Energy (10.3 per cent). The second biggest position is Canadian Oil Sands. For the aforementioned reasons, the composition of the iShares S&P/TSX Capped Energy Fund appears better positioned to capitalize on the industry trends that are expected to shape the sector going forward. This fund is more concentrated in terms of number of holdings (15). Its overall assets stand at a modest $26.2-million, and it yields 0.7 per cent.
Horizons Enhanced Income Energy ETF
This fund seeks to provide a higher dividend yield to its unitholders, deploying a covered-call strategy to attain that objective (100 per cent covered call written, out of the money). Offering a yield of 8.8 per cent, based on the level of its most recent distribution (annualized), the portfolio may capture less of the sector specific dynamics that should see the market value of energy companies appreciate, due to HEE's covered call writing "overlay."
First Asset Can-Energy Covered Call ETF
The fund consists of an equally weighted basket of the 25 largest companies comprising the S&P/TSX Capped Energy Index, rebalanced quarterly. The primary objective of OXF is to deliver distributions to investors, while otherwise lowering the volatility of returns on the portfolio overall, relative to what it would be without the 25 per cent covered call strategy "overlay." While its 9 per cent yield looks attractive, this has been offset by declines in market value.
Outlook
Beyond the sector's pipeline capacity issue, investing in the energy industry is dependent on the underlying commodity prices. The biggest risk is buying in when prices have peaked and the market is on the verge of a correction. Spot prices have been trending upwards, hovering around four-month highs, with West Texas crude trading above $95 a barrel, but overall there are no signs that a bubble is forming, and OPEC has publicly stated it is optimistic, with further price appreciation likely in 2013 as the Global economy continues to heal.
Relative to the S&P/TSX 60, which is overexposed to financials, adding a fund like XEG to a portfolio in order to ratchet up an equity position in energy seems like a prudent choice given the potential for future price appreciation. While short-term prospects may be less certain, underlying fundamentals suggest this sector could be poised to outperform and investors should consider being overweight in anticipation of improving market conditions.
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