At BP Capital Fund Advisors, we believe a differentiating feature of the TwinLine® Energy Fund is that it encompasses the entire energy value chain. In terms of portfolio construction, this means investing in a mix of companies involved in the upstream (exploration & production, as well as oilfield service), midstream (pipelines and transportation), downstream (refineries), and end use (e.g., materials, industrials, and transportation) aspects of energy. Importantly, it is the inclusion of the end user category that distinguishes the TwinLine® Energy Fund from many other energy funds that only consider the traditional definition of energy companies. In this paper, we will explore why we believe such an inclusion is appropriate when investing in energy themes and, moreover, why we believe it is a critical element in seeking to augment returns and mitigate risk in the sector.
A Comprehensive View of Energy. In broad terms, our answer for “Why end user?” lies in our holistic view of energy. Often, the notion of an energy investment focuses on only the supply side of the sector, particularly the upstream segment. Investing in such companies that, for instance, produce oil through fracking horizontal wells or provide rigs to a wellpad is undoubtedly core to an energy fund. Similarly, pipeline operators and refiners are a natural fit when considering the constituents of an energy portfolio. Nevertheless, to have a comprehensive view of energy, we believe one must also consider the impact energy has on companies that consume hydrocarbons. By doing so, investors can participate in both the cause and effect issues surrounding energy.
Fuel or Feedstock? Considering end users is also logical since energy is a critical element of companies’ cost competitiveness in many industries. This relates both to energy use as a power source for corporations or as a raw material for the products they produce. As a power source, energy costs often serve as a defining variable between low- and high-cost producers of a good or commodity. In many cases, producers have little flexibility or few energy source alternatives and must accept any competitive disadvantage presented by higher energy costs. Likewise, in cases where energy is a key feedstock (like chemicals), the relative cost of one hydrocarbon source to another is often a critical determinate of a company’s overall returns and even its financial viability. Considering end users of energy also presents opportunities to invest in companies that can pass along higher fuel or feedstock costs to its customers and potentially even recognize margin enhancement as the economic environment supporting higher energy costs also enables them some level of pricing power.
Expanding the Energy Investment Opportunity Set. Finally, incorporating end user stocks which are meaningfully influenced by energy commodity prices allows an energy portfolio manager to expand his or her investment scope to other sectors and commodities. We believe a frequent mistake among market participants is to focus solely on oil when considering energy investments. Rather, including other commodities, such as associated hydrocarbons (natural gas, NGLs), downstream products (e.g., gasoline, diesel), linked energy products (e.g., LNG, power), as well as end user commodities (e.g., ethylene, steel, paper, copper, cement), significantly expands the investment universe and presents diverse equity opportunities. Moreover, including various industrial and even consumer-led stocks that are also significantly impacted by energy further expands the investment opportunity set.
Practical Effects and Benefits of Including End User Stocks in an Energy Fund
Various Correlations to Oil Prices Among End Users. In general, stocks in the end user segment typically have lower correlations to oil than the stocks of companies that produce, provide services, refine, or transport hydrocarbons. Nevertheless, correlations differ significantly across the end user subgroups. The table below shows the various correlations to the West Texas Intermediate (WTI) oil price for selected commodity and industrial exchange traded funds (ETFs) over the past three, five, and ten years. Unsurprisingly, the two oil-focused ETFs listed (the SPDR S&P Oil & Gas Exploration and Production ETF [XOP] and the VanEck Vectors Oil Service ETF [OIH]) have had the highest correlations to oil prices. This is followed closely by the S&P Metals & Mining ETF (XME) and the NYSE Arca Steel Index (STEEL), likely because of the similar demand characteristics of those commodities with oil. A key connection here is that most of the major metals (e.g., copper, aluminum) are traded in future contracts like oil and, therefore, are similarly influenced by macro variables such as global economic trends and currency movements, as well as sentiment among commodity traders.
Interestingly, the broad materials ETF (the Materials Select SPDR Trust [XLB] – comprised largely of companies classified as chemicals) had negative correlations to oil over the past five- and ten-year periods, possibly due to the diverse demand drivers for many of its key members. Even larger negative correlations over those periods existed with the Industrial Select Sector SPDR Fund (XLI) and the SPDR S&P Transportation ETF (XTN), likely since companies included in those ETFs are not commodity producers and are influenced less by specific supply/demand dynamics.
Provides flexibility to mitigate the impact of falling oil prices. Given the various correlations of end user sectors to oil, incorporating such stocks in an energy portfolio can provide greater flexibility to a fund relative to portfolios only invested in traditional energy subsectors. This flexibility is particularly valuable in allowing a comprehensive energy fund to mitigate the impact of falling oil prices, aiming to reduce downside capture. Conversely, at times of rising oil prices, a higher correlation may be preferred, implying a lower allocation to less oil-correlated end user groups. The overall objective is to utilize the enhanced flexibility to identify asymmetric reward/risk opportunities across the energy value chain.
Enables the portfolio to invest in tangential themes. By including disparate sectors that are significantly influenced by energy, but have alternative key supply/demand and cost drivers, portfolio managers can identify and invest in companies that may be mispriced for various reasons. This simply presents opportunities for alpha generation within the entire energy value chain.
Broadens the energy investment universe. The end user segment of energy naturally encompasses a very large swath of sectors and companies. Almost every company consumes energy to some extent. The manufacturing of practically any good is performed by some amount of energy usage (either as a fuel or feedstock). Also, the distribution of goods relies heavily on various fuel sources. Indirectly, even retailing is substantially influenced by energy prices through what consumers are paying at the pump.
Therefore, using the broad definition of an end user could justify inclusion of practically any company in the category. Nevertheless, we believe it is sensible to include only those companies that are measurably impacted by energy costs and availability. By one gauge, we identify companies that have high levels of energy intensity (EI), as defined by the nominal amount of energy they consume (EC) divided by the value of their shipments or services (VOS).
Energy Intensity (EI) = Value of Energy Consumed (EC) / Value of Shipments (VOS)
Granted, often such figures are not provided by corporations or it may be impossible to accurately compute a company’s energy exposure throughout its business. Nevertheless, this equation provides a logical framework in identifying the most energy-exposed businesses.
The table below lists several end user subsectors, separating them by higher and lower levels of energy intensity. It is important to note in that companies within certain industries can differ significantly by energy intensity. For instance, within building products, some goods like paint or carpet manufacturers rank high in energy intensity, while others like cabinet and door makers are less energy intense. Similarly, in fertilizers, the production of urea (nitrogen) consumes substantially more energy through the use of natural gas as the primary feedstock than that of potash, which is mined.
Four Categories of End Users
A common perception is that the stocks of end users universally have an inverse relationship with oil prices, and that the segment simply represents a hedge to the traditional energy stocks in a portfolio. Granted, this may be accurate for some end users where margins move in direct counter step with oil prices. Still, for many heavy energy consuming companies, this relationship differs considerably. In fact, counter to the conventional notion, some companies have an history of rising profit margins in times of higher energy costs. This dynamic complicates the usual association of end users as an energy hedge. Rather, when considering the impact of including the end user group, we believe such stocks should be viewed in four subcategories.
1.The Cost Takers
These are companies that generally fit the common perception of a hedge in an energy portfolio, as their profit margins tend to have an inverse relationship with energy prices. Such companies may have limited ability to pass along higher energy costs, or higher energy prices may negatively impact consumption levels among their customers. Airlines and trucking companies are two examples of traditional cost-taker industries. While companies in both industries may seek to pass along higher fuel costs through surcharges and price increases, achieving those higher prices in a competitive environment may not be successful or fully offset the rise in costs. Also, the higher prices may drive down consumption levels among customers. As such, profit margins among both sectors have often trended counter to oil price movements.
2. The Cost Pushers
The type of companies that can be considered cost pushers is quite diverse, and is often determined by the dynamics a particular industry (e.g., highly consolidated, local in nature), as well as a company’s competitive position within its industry. For example, within building products, Sherwin Williams could be viewed a cost pusher. As a manufacturer and retailer of architectural paint, much of Sherwin’s costs are tied to oil prices. Exhibit 5 shows the raw material cost breakdown of a gallon of paint, illustrating the heavy reliance on oil-based materials like resins/latex. However, given its strong branding and advantageous positioning within the coatings industry, Sherwin historically has been successful in increasing prices to offset rising oil-related costs. As such, its revenues and profits tend to be driven more by economic factors such as existing home sales.
The cost pushers are companies that incur higher energy costs, but have shown an ability to pass along such higher costs. Thus, while they may be large consumers of energy, their revenues and profit margins are typically more influenced by other factors, such as supply/demand of a specific good, currency movements, geographic exposures, labor, or other commodity costs.
Similarly, tire manufactures, like Goodyear Tire, seem to fit in the cost push category. As shown in Exhibit 7, Goodyear states that 65% of its raw materials are influenced by petrochemical prices. Nevertheless, it has a proven track record of pushing through such higher costs via price increases. Therefore, in the end, its margin and profit growth have been led more by global auto trends like vehicle miles traveled and new car sales, as well as company-specific initiatives and trends within the tire industry. That’s not to say energy costs are not an important factor to consider when analyzing Goodyear, but simply is a variable that has been managed well by the company.
3. The Margin Enhancers
For instance, earnings for steel companies have shown a strong correlation to raw material and energy costs. Exhibit 8 illustrates the strong correlation between changes in the average US hot rolled coil (HRC) price and the WTI oil price in recent years. This relationship also helps to explain the strong correlation of the steel ETF (STEEL) to the oil ETFs (XOP and OIH) mentioned previously.
Some end user companies not only are able to pass through higher costs, but often enjoy some margin expansion in times of heightened energy prices. A key reason is that the same demand factors helping to drive energy prices higher are often also positively influencing the demand for the goods or commodities they produce. Therefore, such companies tend to attain some level of pricing power and recognize strong volume growth during times of energy price inflation.
Other commodity producers also seem to enjoy margin expansion in times of higher energy costs. This is particularly the case for metal producers. Copper, for instance, has many of the same broad global economic demand drivers as oil, and is similarly traded in forward contracts. As shown in the regression analysis below, copper has long history of being highly correlated to oil prices. Logically, margin expansion would result for copper producers when the commodity they produce is moving in close lockstep with oil prices, yet only a portion of their costs is experiencing similar inflation.
Finally, some end users experience a relative cost benefit with changes in energy prices, as other producers find themselves competitively disadvantaged by being dependent on a higher-priced energy source. These differences in energy sources and availability are often determined by the location of a company’s production facilities. As an example, in recent years, low prices for natural gas liquids – NGLs (due to increased US natural gas production) has given domestic ethylene producers a substantial benefit over ethylene producers abroad, whose key raw material is naptha (an oil derivative). As a result, the ethylene margin realized by US producers has tended to move in tandem with the ratio of the Brent crude price to the market price of Mt. Belvieu ethane (the main NGL used to produce ethylene in the US).
Similarly, North American producers of other energy intensive commodities, like aluminum, have recently experienced a favorable cost advantage over producers in China, where thermal coal is the main power source. For the North American aluminum producers, natural gas and hydro are the main power sources behind their production. Thus, the latest spike in Chinese thermal coal prices, driven by the country’s pollution-control measures, has opened a large cost gap in the industry, dramatically favoring the North American producers.
West Texas Intermediate (“WTI”) is a grade of crude oil used as a benchmark in oil pricing.
Henry Hub Spot Price references the Henry Hub natural gas pipeline that serves as the official delivery location for the spot price and futures contracts on the New York Mercantile Exchange (NYMEX).
The views in this material are intended to assist readers in understanding certain investment methodology and do not constitute investment or tax advice. Please consult your tax advisor. The views in this material were those of the author as of the date of publication and may not reflect their view on the date this material is first published or any time thereafter.
Investors should consider the investment objective, risks, charges, and expenses of the BP Capital TwinLine Funds carefully before investing. A prospectus with this and other information about the Funds may be obtained by calling 1-855-40-BPCAP (1-855-402-7227). Please read the prospectus carefully before investing.
As with any mutual fund, it is possible to lose money by investing in the BP Capital TwinLine® Funds. An investment in either Fund is subject to other risks that are more fully described in the prospectus, including but not limited to risks in Master Limited Partnerships (“MLPs”) include, cash flow, fund structure risk and MLP tax risk plus regulatory risks. The prices of MLP units may fluctuate abruptly and trading volume may be low, making it difficult for the Funds to sell its units at a favorable price. Most MLPs do not pay U.S. federal income tax at the partnership level, but an adverse change in tax laws could result in MLPs being treated as corporations for federal income tax purposes, which could reduce or eliminate distributions paid by MLPs to the Funds.
An investment in the BP Capital TwinLine® MLP Fund is, also, subject to risks, include but are not limited to non-diversification, energy-related sector, small-cap and mid-cap stocks, initial public offerings, high-yield “junk” bonds, and derivatives. The Fund is treated as a regular corporation, or “C” corporation, for U.S. federal income tax purposes. Accordingly, unlike traditional open-end mutual funds, the Fund is subject to U.S. federal income tax on its taxable income at the graduated rates applicable to corporations (currently a maximum rate of 35%) as well as state and local income taxes. The Fund will not benefit from current favorable federal income tax rates on long-term capital gains, and Fund income and losses will not be passed on to shareholders. The BP Capital TwinLine® MLP Fund may, also, invest in MLPs that are taxed as “C” corporations.
An investment in the BP Capital TwinLine® Energy Fund is, also, subject to risks, include but are not limited to non-diversified, energy-related sector, small-cap and mid-cap stocks, initial public offerings, high-yield “junk” bonds. The Fund expects that a significant portion of its distributions to shareholders will be characterized as a “return of capital” because of its MLP investments. If the Fund’s MLP investments exceed 25% of its assets, the Fund may not qualify for treatment as a regulated investment company (“RIC”) under the Internal Revenue Code (“Code”). The Fund would be taxed as an ordinary corporation, which could substantially reduce the Fund’s net assets and its distributions to shareholders.
Shares of the Funds are distributed by Foreside Fund Services, LLC, not affiliated with BP Capital.