Can Energy Stocks Still Provide a Safe Source of Income?

With oil prices below $45 a barrel can investors rely on energy companies for yield? Fund manager Tineke Frikkee thinks so

Emma Wall 4 August, 2016 | 8:00AM
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Emma Wall: Hello and welcome to the Morningstar Series "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Tineke Frikkee, Manager of the Smith & Williamson U.K. Equity Income Fund.

Hello Tineke.

Tineke Frikkee: Hi there.

Wall: So I had a look at your fund's portfolio and there is about 8.5% in energy stocks. The top two holdings of the fund are BP (BP.) and Shell (RDSB). I thought that was really interesting because a lot of U.K. equity investors have been scared of this sector, in particular those looking for yield. So why do you continue to find it compelling.

Frikkee: Earlier this year I had a sense that we were in a more stable [oil price] range, maybe somewhere between 40 and 50. And as we sort of approached the second quarter of reporting. We started to think about the third quarter of reporting and we kind of nearly closed to the oil price level where we were year ago. So that sort of gave me a little bit of comfort that maybe we are getting close to stabilisation in earnings.

So from having no oil stocks I went to 8%, I might have even ticked slightly higher in that on BP and Shell. High dividend yields, still not worth that risk, because certainly at the moment and both stocks have reported last week. Earnings are still going down debt is going up. But the shares aren’t particularly expensive from a price-to-book and the dividend yields for now, for this year, they look fine, but it's certainly something that I think has scared off lots of equity income investors, because we obviously we want yield and is it sustainable.

Both companies will need the oil price to get to 60 to start, sort of having a sustainable level. But for now we are sort of happy with risk reward profile. Saying that the stocks have performed very strongly. Both these names have sort of gone about 30%.

Wall: And oil did make up quite a stable part of the sort income world for some time. For a long time, oil stocks and banking stocks were the backbone of any good income portfolio. Then we entered a period where both those sectors cut dividends either down or entirely. So would you say that as an income manager now you have to be a lot more active than perhaps you did in the past following the global recession and the oil price fall.

Frikkee: Overall I think yes being active has a big advantage in a more volatile stock market and that’s sort of regardless of what you just touched on, because you are absolutely right. The banking sector was top income sector in 2007. The big oils haven’t cut dividends, but certainly the more oil exploration companies have cut and it's because they don’t have any free cash flow. So if you don’t make any money it's very difficult to pay the dividends.

But it is absolutely key to avoid stocks that cut, because they tend to do this out of distress and we've seen a lot of cuts in the mining sector, which good fund manager could have seen that coming. You could see the net debt rising and the cash falling and that’s just not sustainable. My fund has no mining stocks. I still think that the risk reward isn’t right there. But overall I think it is important to diversify where your dividends come from.

The big oils and some other large U.K. stocks are helped by the dollar so we are at about 1.33 to the dollar. So a strong dollar, companies that declared dividends in dollars you get a little bit more bang for your buck in the sterling. But that’s not always the case. So I think being nimble is important to diversify your income. But also get that risk reward right otherwise you might just be in too risky stocks.

Wall: Tineke, thank you very much. This is Emma Wall from Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar