Switch Your Oil Holdings For A Better Yield

Adam Fischbaum's picture

Wednesday, December 28, 2016 - 11:30am

by Adam Fischbaum

Save for early punk rock and a few obscure power pop bands, I'm not a huge fan of '70s rock-n-roll. Rooted as a blues band in the late '60s, the Steve Miller Band grooved into the '70s and managed to crank out a few catchy radio mega-hits that are still staples of classic rock radio to today. Ok. You know where I'm going with this, don't you?

When stocks rally big time, I can hear the "Hoo! Hoo!" vocal hook of the SMB's "Take the Money and Run" in my head as valuations get pushed to what I consider silly levels. I'm hearing it now as I look at a few stocks in the oil sector.

Black gold has been on an absolute tear since the beginning of 2016. After a merciless pounding thanks to the one-two punch of a strong dollar and a global supply glut, oil has rallied 46% to nearly $54/bbl from its basement low of $37/bbl.

Is there any room left in the oil rally? Maybe. OPEC members recently reached an agreement to curb production by 2% with the goal of creating price stability and curbing the surplus. On the domestic front, rig count in the United States has fallen, keeping with OPEC's production dial-back. Despite these efforts, analysts are calling for $60/bbl for crude on the top end. So, at $54/bbl, there's a bit of an upside but it would seem as if the train has left the station.

One of the direct beneficiaries of the recent recovery in oil prices has been oil giant Chevron (NYSE: CVX).

Those bold enough to buy shares below $80 have enjoyed a more than 50% run with a 3.62% dividend yield that pushes the total return well over 60%. Cue the Steve Miller Band hit.

But while there is little doubt that Chevron is one of the highest quality plays in the energy space, the stock has gotten way ahead of itself. At around $119, the stock trades with a forward P/E of 90. The company is expected to deliver earnings per share (EPS) of $1.34 for 2016, 42% short of 2015 EPS of $2.46.

While 2017 estimates call for EPS of $4.55, it's a hard row to hoe. The company has crawled back from the oil crash admirably. But the company had negative free cash flow of around $16 billion last year and is expected to experience the same for 2016. Chevron has committed to capex spending of $20 billion and to raising its annual dividend, but negative free cash flow makes keeping these promises difficult.

That said, there is still value in the energy space and investors should maintain exposure to the sector. One of the best all round choices is the Alerian MLP ETF (NYSE: AMLP) for current income and upside.

Tracking the Alerian MLP Infrastructure Index (AMZI), AMLP holds a basket of 27 master limited partnerships (MLPs) that derive most of their cash flow from energy infrastructure, including transportation, processing, and storage. Top holdings include the biggest players in the energy infrastructure business such as Magellan Midstream Partners (NYSE: MMP), Enterprise Products Partners (NYSE: EPD), and Plains All American Pipeline (NYSE: PAA).

At around $13, AMLP shares have enjoyed the oil rally by rising 64% from their bottom of $7.77 while still trading at a slight discount to their net asset value (NAV) of $12.70. But with an average forward P/E of 23.4 and a dividend yield of 7.55%, the ETF is a bargain next to Chevron.

Risks To Consider: The incoming Trump administration is decidedly fossil fuel friendly, with a nominee slate that reads like an oil patch who's who. This would indicate that the energy rally could go into overtime. Even though investors are always afraid of leaving money on the table, a one year gain of 56% is darned respectable. Risk management is always good business.

Action To Take: In an all-around strange year, investors who included Chevron in the mix have been well rewarded. Taking profits, even partial profits, at this point would be the prudent move. New money in CVX is not advised. AMLP, with a diversified basket, modest valuation, and 8.4% yield, is a better choice for new exposure to the energy sector or reallocation of capital.

Editor's Note: These are our Top 10 "win-win" stocks for a chaotic 2017. No matter what Trump does (or how the markets respond) these stocks are poised to soar into double-digit gains over the next few months. Check out the list here...

Adam Fischbaum owns shares of AMLP.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.