Investors must eat some losses before regaining taste for energy sector

Buy at low prices from those selling in disgust

Irecently had lunch with Bob and Jim, two investor friends. Bob was unhappy with the performance of his stake in the iSharesS& P/TSX Composite Energy Index Fund (XEG/TSX), which on the surface appears to be the safest way to invest in the Canadian energy sector. The $780-million fund’s top holdings include Suncor Energy Inc. (17.8%), Canadian Natural Resources Ltd. (11.4%) and Cenovus Energy Inc. (9.7%), and has stakes in many of the other big industry names as well.

The diverse portfolio of industry giants, however, has not protected unitholders from the slump in both oil and gas. Shares of Talisman Energy Inc., for example, are down more than 40% over the past year, while Encana Corp. and Canadian Natural ResourcesLtd. are both off about 30%. Even integrated producer Suncor Energy Inc., which owns refineries and gas stations and is therefore less exposed to oil and gas prices, is down about 20% since July 2011.

Units of XEG are down 10% this year and about 25% over the past year; most of the pain was suffered last summer. The long slide in oil prices means units of XEG, which traded for more than $20 last summer, now sell for about $15, the lowest they’ve been since the great market slump of late 2008 and early 2009. The fund, which has a management expense ratio of 0.55%, has paid out distributions of 10.5¢ and 9.6¢ per unit this year, on track for an annual yield of about 40¢, or 2.7%. The payouts have reduced unitholders’ pain to the point where they are only 22% poorer than they were a year ago.

Since oil and gas prices are cyclical, there is no doubt the fund will rebound — the only question is when. Investors in their twenties with many years of working life ahead of them can wait, but Bob, who invests only in ETFs, is in his fifties.

“I’m running out of patience,” said Bob, opening his laptop computer and calling up a chart of the fund. “Eventually, I’ll have to switch to income ETFs, but I was hoping for a little growth until then.”

Bob won’t buy individual stocks and wants to research his own ETFs. Since analyst reports on ETFs are somewhat tricky to find, Bob said he planned to cough up $150 a year for Morningstar’s premium service “to help me find funds that grow.”

Our other luncheon diner, Jim, has exposure to the Canadian energy sector only through shares in Imperial Oil Ltd. (IMO/TSX), whose shares have taken less of a beating. They’re down 4% this year and flat over the past year. Imperial is an integrated producer that profits from refining and marketing as well as producing and hasn’t suffered as much as the “upstream” companies. Imperial Oil also has a beta — the measure of an investment’s volatility compared to the index — of just 0.53 vs. 0.95 for XEG. Those seeking less volatile investments should always check the beta.

At the end of the lunch, Jim said he was holding onto his Imperial Oil shares, but Bob said he might sell XEG.

“I’d buy your units,” said Jim, leaning over to point at the price chart of the fund on Bob’s laptop. “Look, you can only get these for $15 once every three or four years. They’re on sale. What are the chances of Suncor going bankrupt? CNQ? Cenovus?”

As f or Imperial Oil, I checked the Bloomberg terminal back at the office and found analysts are generally lukewarm. Of the 16 analysts who follow Imperial Oil, 10 see it as a hold, two say sell and only four regard it as a buy. Among those is Paul Cheng, an analyst at Barclays Capital Inc. in New York, who has a $60 price target on the stock, 37.3% over Friday’s close of $43.69.

“Longer term, we still think IMO represents one of the best ways to gain Canadian oil sands exposure,” Mr. Cheng said in a recent report. “We believe IMO represents the best of ExxonMobil and we reiterate our overweight rating.”