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Income Investing

A Bargain-Priced Super Oil

By Roger S. Conrad, on Jun. 15, 2013

Standard & Poor’s this week lifted its outlook for the US government’s credit to “stable” from negative. However, the price of US Treasury securities has continued to decline; the yield on the benchmark 10-year Treasury note has surged to 2.2 percent from 1.6 percent at the end of April.  

Although yields on Treasury notes remain low by historical standards, the recent uptick demonstrates the adage that good news for the economy is usually bad for bonds.

Over the past five years, fear-induced rallies in Treasury bonds have been an annual event, from a record six-week run at the height of the 2008 financial crisis to the last year’s flight to safety amid concerns about the US’ fiscal health and Congressional gridlock.

The conventional wisdom holds that a rally in the bond market bodes well for utilities, master limited partnerships (MLP), real estate investment trusts (REIT) and other interest rate-sensitive stocks. But all three of these income-oriented groups have pulled back with the rest of the stock market each time bonds have rallied. When the flight to safety eventually ended and bond prices retreated, these securities surged with the rest of the market.

Time and time again, these stocks have proved their sensitivity to the economy and market–not interest rates. With benchmark interest rates likely to head higher into the summer, that’s food for thought.

Source: Bloomberg, Capitalist Times

 “Tenuous Correlations” tracks the performance of four dividend-paying equity groups, as well as the S&P 500 and the Chicago Board Options Exchange 10-Year T-Note Yield Index.

Over the past five years, the yield on 10-year Treasury bonds has tumbled by 46.5 percent, while the Alerian MLP Index, the Bloomberg North American REIT Index, the Dow Jones Utilities Index and the NYSE Arca Oil Index have all drafted higher. At the same time, the S&P 500–which few would consider rate-sensitive–has outperformed the Dow Jones Utilities Average by a better than 2-to-1 margin. In fact, energy-related MLPs were the only dividend-paying group to vastly outstrip the five-year return posted by the S&P 500.

If these indexes were truly sensitive to interest rates, they should have outperformed the S&P 500 handily.

The conventional wisdom breaks down even further when you compare 12-month returns: All the dividend-paying indexes in our informal survey had generated positive returns, despite a 38 percent upsurge in the yield on 10-year Treasury notes–the opposite of how stocks that are sensitive to interest rates should have performed.

That being said, the performance of the Dow Jones Utilities Index and the Bloomberg North American REIT Index since April 30, 2013, exhibits some of the traditional correlation between interest rates and dividend-paying equities. Still, the losses posted by these indexes have yet to hit double digits, while the yield on the 10-year Treasury note has increased by 32 percent.

Given the conventional wisdom about the relationship between Treasury yields and income stocks, the recent selloff of MLPs, REITs and utilities makes sense. Moreover, these security classes were due for a breather after a significant run-up.

Investors shouldn’t confuse this recent pullback as an early signal to sell their income stocks; rather, this weakness represents the best opportunity to add exposure to high-quality names since last fall.

We expect the environment for income-oriented fare to remain sanguine. Prices have come in on longer-duration bonds, but this phenomenon hasn’t crept into other segments of the fixed-income market. Meanwhile, the Federal Reserve appears committed keeping interest rates low until the US unemployment rate shrinks to historical norms in the neighborhood of 6 percent. Although we’ve seen progress on this front, the labor market has a ways to go.

The supply and demand equation likewise remains favorable, with institutional investors still pulled to the superior yields and growth potential offered by equities. And we expect this trend to continue.

Investors should be prepared for yields on 10-year Treasury note to tick up to between 3 and 4 percent over the next 12 months to 18 months. Based on this outlook, most bonds appear terrible investments right now, especially long-dated US Treasuries.

In this scenario, investment-grade corporations should still have inexpensive access to capital by adjusting the maturities on their bond issuance. We continue to focus on income-oriented equities that trade at reasonable valuations and/or offer the prospect of solid dividend growth. To that end, the recent weakness afflicting traditional dividend-paying groups represents the buying opportunity for which we’ve been waiting.

Our favorite stocks right now are high-quality names that have been buffeted by two contradictory fears: rising interest rates and weak economic growth. Given the Federal Reserve’s current posturing, rising interest rates are unlikely to occur without a healthier economy.

One name that fits the bill in our Lifelong Income Portfolio: Total (Paris: FP, NYSE: TOT), the France-based international oil company. Like the handful of other Super Oils, Total owns and operates both upstream (exploration and production) and downstream (refining, chemicals and marketing) assets. With exposure to all levels of the energy value chain, the French energy giant captures value when hydrocarbon prices rise and when they fall.

Moreover, the company’s bulletproof balance sheet enables the firm to weather even the most hazardous storms. The proof is in the pudding: Total still grew its dividend in late 2008 and early 2009, when the price of Brent crude oil to less than $40.00 per barrel from a high of almost $150.00 per barrel.

No wonder that investors often regard Total and other integrated oil companies such as Chevron Corp (NYSE: CVX) and ExxonMobil Corp (NYSE: XOM) as the safest harbors in the energy patch.

Total’s continued dealings with Iran recently landed the international oil company in hot water. But the US$398 million that the firm agreed to pay to settle the associated bribery cases is a drop in the bucket when you consider the US$13.4 billion in cash on its balance sheet.

The biggest challenge for Total–or any of the world’s largest energy companies–is to grow reserves and production from such a huge base. Although the French integrated oil company’s hydrocarbon output has remained relatively flat in recent years, the firm is pursuing a portfolio of 25 growth projects that management expects will fuel average annual production growth of 4 percent between 2013 and 2015.

Nine of these developments are in Africa, historically an area of strength for the company. Although these higher-risk, higher-reward developments entail some risk of delay, there’s enough diversification to offset challenges on a particular project.  

Over the past three years, Total has dished out an average of US$22 billion in annual capital expenditures, a figure that’s expected to grow to US$18.7 billion (excluding acquisitions) over the next 48 months. An estimated US$20 billion in asset sales that will wind down in 2014 will help to fund the company’s growth projects.

With management’s guidance calling for annual free cash flow to average US$7.5 billion over the next four years, Total has ample room to grow its dividend, service its debt and finance additional growth opportunities.

With Brent crude oil at $100.00 per barrel, Total should be able to grow its dividend at an average annual rate of at least 7 percent and still keep its payout ratio below 50 percent. Add in a current yield of more than 6 percent and you have an impressive prospective return.

Longtime favorite Chevron remains investors’ best bet based on production and reserves growth. However, Total offers impressive upside at a superior valuation.

Note that although the French energy giant pays its dividends in euros, the company accounts for its earnings in US dollars–the global currency for oil and most commodities. As a result, the firm’s profits haven’t suffered from euro-related weakness. 

Roger S. Conrad is founder and chief editor of Capitalist Times and Energy & Income Advisor

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