Guest Contribution By Tom Hutchinson, Chief Analyst, Cabot Dividend Investor
Energy was by far the worst performing S&P 500 sector until recently. While the S&P 500 had recovered and eclipsed the pre-pandemic high by last summer, energy stocks continued to wallow in a bear market. The Energy Select Sector SPDR Fund (XLE), which tracks an index of energy stocks on the S&P 500, was still down more than 50% from the pre-pandemic level by the end of October.
Then came the vaccine.
The announcement of the first vaccine in early November changed everything. The vaccine promised to end the lockdowns and remove the economic shackles, unleashing a full recovery and booming economy in 2021. Cyclical or real economy stocks rallied like crazy. The XLE soared a remarkable 86% between late October and the beginning of March. It has since leveled off.
Now what?
Despite the furious energy rally, the XLE is still about 15% below the pre-pandemic price. Many strong, cheap energy stocks are also still well below pre-pandemic levels. But here’s the thing: The environment for energy stocks stunk before the pandemic. The high-growth environment in the coming months should deliver much higher profits than before the pandemic.
Although it’s true that energy is the best performing market sector YTD, the industry is climbing out of such a low level that many stocks are still cheap. Current valuations and yields combined with powerful growth in the months ahead make energy stocks attractive.
Here are three good ones.
ONEOK Inc. (OKE)
- Dividend Yield: 6.7%
ONEOK is a large U.S. midstream energy company specializing in natural gas. It owns one of the nation’s premier natural gas liquids (NGLs) systems connecting NGL supply in the Rocky Mountains, mid-continent and Permian regions in key market centers, and also has an extensive network of natural gas gathering, processing, storage and transportation assets. A whopping 10% of U.S. natural gas production uses ONEOK’s infrastructure.
The market performance has reflected the high quality, at least it did before the pandemic. In the 10 years prior to the pandemic OKE returned 427% and returned over 100% in the five years prior. Both were nearly double the market returns over the same period. But OKE fell more than 75% in the bear market. Although OKE has returned over 43% YTD, it’s still 30% below the pre-pandemic price.
That’s a bargain because, despite the challenges of the pandemic, ONEOK grew earnings 6% in 2020. It also estimates double-digit earnings growth for this year. OKE is still 30% below the pre-pandemic levels with higher earnings ahead of a likely huge energy recovery later this year.
ONEOK is a quality high dividend stock.
Enterprise Product Partners (EPD)
- Distribution Yield: 7.5%
Enterprise is a Master Limited Partnership, or MLP for short. It is one of the largest midstream energy companies in the country, with a vast portfolio of service assets connected to the heart of American energy production. It is connected to every major U.S. shale basin as well as 90% of American refiners east of the Rockies, and it offers export facilities in the Gulf of Mexico.
The key to remember is that it’s a fee business that collects tolls for oil and gas moving around the country and has low exposure to volatile commodity prices. As a result, earnings were remarkably resilient during the pandemic. But the MLP got crushed along with the bathwater anyway.
EPD has lagged most energy stocks during the recent rally because profits aren’t rebounding as quickly as companies with greater commodity price exposure. But earnings never fell as much as most energy stocks. The stock is clearly moving the right way. It also pays a massive yield that’s extremely safe.
Even in one of the toughest years ever for the industry, Enterprise still covered the distribution by 1.6 times with distributable cash flow. That’s about as good as it gets in this industry.
The stock is cheap and rising but it still hasn’t gotten ahead of itself. It’s still a great time to buy this stock. You can earn a massive yield on a stock that is very likely to continually appreciate over the course of the year.
Valero Energy (VLO)
- Dividend Yield: 4.9%
Valero is the largest petroleum refiner in the U.S. It has 15 petroleum refineries and markets products in 43 states, Canada and the U.K. It is also one of the largest producers of ethanol and has a rapidly growing renewable diesel business.
It is the best refiner because it is the most technologically advanced and has some of highest and most resilient profit margins in the business. But none of that is the main story for this stock right now. It’s all about the recovery. Refiners are extremely cyclical. And Valero is a high leverage play on a full economic recovery later in the year.
As demand for gasoline and diesel crashed during the pandemic, VLO got crushed. In late October, VLO was down 50% from the pre-pandemic high and 70% from the all-time high.
But the things are reversing in a big way. Since the pandemic announcement in November, the stock is up over 100%. The full recovery that the vaccine promises will most certainly lead to a big increase in demand for oil and gas.
VLO is still priced well below the pre-pandemic high. And things weren’t that good for refiners then. The post-pandemic environment is shaping up to be much better for refining margins. VLO has great momentum and likely much more upside over the course of this year.
