The Effect of Low Oil Prices on Your Portfolio

August 2015

The Effect of Low Oil Prices on Your Portfolio

Energy and energy distribution make up about 15% of many of our client portfolios. Let’s look at how the price of oil has dropped recently and how that has affected your assets.

Screen Shot 2015-09-02 at 3.46.54 PMIn the fourth quarter of 2014 crude oil prices declined 41% from $91 per barrel to $53 per barrel according to a TransUnion study. In 2015 the price rebounded slightly only to decline again along with the number of active drilling rigs in our country to the lowest number in decades (see chart). Crude oil prices are volatile: Seven years ago oil topped out at $145 in July, 2008 and fell as low as $30 per barrel merely five months later.

We invest in energy companies for the same reason we invest in any company, energy is essential and used across many industries: transportation, manufacturing, power generation, and in the production of various plastic products. This is a great area to invest in, but is not without volatility due to crude oil prices. We believe the long-term benefit of these energy companies outweighs the volatility of crude.

As always, we remain focused on dividend and interest income (the golden eggs) and dividend growth that will encourage long-term capital appreciation (fattening the goose) in your portfolio. The last three months returns, however, have been disappointing and this is never fun. Josh Peters, CFA from Morningstar, someone we trust to help inform us on the positions in your account, had this to say recently, “For more than 10 years I’ve insisted that short-term relative performance would not (1) define our success or (2) affect the way we manage our strategy.” This has proven to be an excellent strategy when looking at his long-term market beating track record.

On a total-return basis that includes dividends, the S&P hit its most recent record on May 21, but the Morningstar Dividend Leaders index topped out several weeks earlier, and the Dow Jones U.S. Select Dividend index hasn’t set a new high-water mark since Dec. 29, 2014. The recent highs for your portfolio were reached in May and since then have declined ~5%, while the Dow is now negative for the year…again.

Nowhere is this underperformance more obvious than in our largest holdings in the energy sector: ChevronMagellan Midstream PartnersSpectra Energy Partners, Energy Transfer Partners and Linn Energy. While utilities, REITs, and industrials have all lagged in recent months, these positions explain the bulk of the recent underperformance.

To a certain extent, we understand why these names are being tossed overboard. The price of crude oil is dropping again as Iran regains access to global markets and energy demand shows few signs of improvement. This can’t help but have a negative effect on Chevron and other oil producers’ near-term profits. Morningstar continues to believe $75 a barrel is a reasonable long-term oil price assumption, and at that level we expect Chevron and Linn to return to business as usual.

If the effect of a short-term drop in oil prices should be relatively minor for Chevron, it’s even less significant for pipeline operators like Magellan, Spectra, and Energy Transfer. In general, low prices for both oil and natural gas will discourage drilling in North America, which in turn limits expansion opportunities for the pipeline operators. Growth opportunities for the pipeline operators may erode somewhat if energy prices remain low for many years to come. However, we remain highly confident in the pipeline selections.

The most aggressive position in the portfolio is Linn Energy. This exploration and production company does not have as strong a balance sheet as Chevron, and we’re seeing the price plummet as a result. This is another great example of why diversification is paramount in investing. We still believe Linn will make it through these days of low priced oil and as the price of a barrel moves closer to $60, the investments in Linn should increase back to a more reasonable level. In the meantime the bond is paying 10%+ interest while we wait.

In short, Josh Peters, CFA, the Morningstar team, and we think the market is overreacting to bad short-term news in the energy sector and negative momentum in stock prices, and it’s hardly unusual for investors to toss the babies out with the bathwater. With the prices of these energy companies down near 20% year-to-date, we view this as an opportunity to rebalance the accounts and take advantage of these low prices.

The Latest AdditionLily

We introduced our newest staff member, Brian Bradley, to you in October of 2014. A week ago Brian and wife, Britney, welcomed, (nine pound!) Lily, their THIRD daughter into their family. Please congratulate Brian with us! Also, keep him in your thoughts and prayers as he learns to navigate a household outnumbered four to one.

We welcome your calls to discuss any details about your financial situation further. Please don’t hesitate to call.

-Bruce & Tim