How to make money in oil regardless of market conditions
Drilling for oil can be such a boring job. ? At least it provides a good income, though. But it’s becoming harder these days to find work in the oilfields. A year ago oil was trading at $90/barrel. Today, WTI has fallen below $40/barrel. Canadian crude is selling for even less, at around $30/barrel. Ouch!
Many oil producers are currently operating at a loss because $40/barrel is below their break-even point. It can take many years for oil prices to turn around. The problem is we don’t know exactly when the recovery will happen. If we did, we would probably all be retired right now. 🙂
Oil stocks are not doing so hot these days. However, there are other ways to still make money from the oil industry, despite the bleak market conditions. 🙂 One way is to write covered calls. But today I’d like to discuss a different approach.
Since the start of this year, Western Energy Services Corp (WRG), has lost about 23% of its value. It could be worse, considering the price of crude oil has fallen about 27% over the same period. But who knows how much lower WRG shares can fall if the price of oil drops further? Fortunately, this company also issues bonds.
When Stocks Underperform, Look Towards Bonds
So last week I bought $5,000 face value of Western Energy Services bonds, with a 7.875% coupon interest rate, maturing in January 2019. I was able to buy it pretty much at par value, which is nice. 🙂 Even though the company is barely making a profit, it’s still obligated to pay me 7.875% every year. Interest is paid to bond holders before dividends are paid to shareholders. ?
Related Post: What is a bond?
Thanks to the new bond investment my passive income is now $393.75 a year higher. Woohoo! ? The yield to maturity for this high yield bond is about 8% a year. This rate of return is safe 🙂 as long as the company doesn’t file for bankruptcy protection before January, 2019. Here are some benefits of buying the bond of this company rather than its stock.
- The bond pays 8% annual return. The stock only pays a 6.5% annual dividend.
- Bonds are inherently less risky than stocks.
- The stock dividend might get cut if the price of oil remains at these low levels. But the bond interest rate does not change.
- If the company goes bankrupt the stock holders will lose all their money. But the bond holders can liquidate the company’s assets to recoup some of their losses.
The analysts’ consensus for WRG is still a “Buy” right now despite low energy prices. And they all expect the share price to be higher 12 months from now.
Based on its net profit margin of 2.3%, WRG is among the most effective companies in its industry at turning revenues into profit. With the maturity date approaching in just under 3.5 years, it’s unlikely the business will go under before I get my principal back. Obviously I could be wrong, lol. But that’s why I’ve only put $5,000 into it. It’s no big deal if I lose it all. ? One drawback of bonds, of course, is there is no capital appreciation. If WRG shares increase 100% by 2019 then investing in the company’s stock today would be more profitable. But since I can’t accurately predict the price of oil in 2019 it’s better to be cautious. This isn’t the first time I’ve bought high-yield bonds.
A Uniquely Balanced Oil and Gas Portfolio
My plan is to purchase and hold the stocks of large-cap, blue-chip energy producing businesses. Then balance out these stocks by owning the bonds of mid-cap or medium-sized oil companies.
For example, large energy stocks like Suncor have dividend yields around 3.5%. Junk bonds from medium-sized energy companies are paying about 8% yield. So you can have a 65% weighting in energy stocks and 35% in speculative bonds, for an average portfolio yield of 5% a year. This return is all you get if oil remains at $40/barrel for the foreseeable future. But if the price of oil increases, you can expect additional returns through dividend increases and capital gains. 😀 The long-term average expected return of this strategy is 7% to 9%.
So in good times, the stock portion of this portfolio will do very well. Companies like Suncor have raised dividends almost every year for the past decade. Then in bad times, the fixed income (bonds) portion will continue to generate 8% a year while you wait for the oil and gas industry to recover. The equity portion should be fairly resilient due to the high-quality names in there. Suncor shares are only down 7% year-to-date, about the same as the broader TSX Composite index.
This asset allocation reduces one’s losses in bear markets and captures the gains in bull markets. Awesome sauce! Over time, this should prove to be a lucrative way to invest in the oil and gas sector, without exposing the investor to unnecessary risks. 😀 But as one approaches retirement it would be prudent to shift the weighting to 50% stocks, and 50% bonds. Furthermore, high-yield bonds should be gradually replaced with investment grade bonds rated BBB or higher.
Unlike stocks, the minimum settlement for bonds is usually $1,000, but in some cases it can be $5,000 or $10,000. Also, junk bonds can be risky and illiquid so it’s not for everyone.
Random Useless Fact: