By now, if you hold any energy stocks, you are probably feeling a lot of pain thanks to the decline in oil prices. My first piece of advice is not to panic, and to hold on to your energy holdings.
As I’ve written many times, energy is a “forever hold” sector. The world needs oil, and that’s not changing anytime soon. We’ve seen several oil crashes over the past 20 years. This, too, shall pass. In fact, we are probably getting close to a point where you can add to your positions.
What you should be concerned about is “oil contagion,” in which other investments that are not intuitively linked to oil prices might get hammered as well. These investments aren’t going to be permanently ruined, either, but you may want to consider rotating out of them until things settle down.
A lot of energy stocks issue high-yield bonds in order to finance their operations. Because oil is a commodity with (obviously) susceptibility to large price swings, the bonds issued in this sector tend to offer higher yields to reflect the higher risk of those crazy oil prices.
Well, now the bonds for energy stocks are under pressure. A high yield means nothing if the price of the bond, or bond funds, fall dramatically. In the case of smaller energy stocks and oil service stocks, these companies may find themselves in a liquidity crunch. With oil prices low, it isn’t profitable enough to continue business (e.g. drilling) at the same rate. The cash flow needed to pay the bond interest suddenly becomes harder to come buy, which means it may be difficult to pay off the bond at maturity. It will likely lead to higher refinance rates as well.
The other problem is that a selloff in these high-yield bonds may induce selling in other high-yield bonds. Even though other sectors may have nothing to do with energy stocks, they may sell off irrationally. Bond funds that have a basket of high-yield bonds may see their prices fall precipitously as investors bail on those funds.
Seek Out Preferred Stock
So I would rotate out of those funds altogether and into a preferred stock ETF. The iShares S&P US Pref Stock Idx Fnd (ETF) (PFF) and SPDR Wells Fargo Prfd Stk ETF (PSK) are both good choices, as they have virtually no exposure to oil prices, but are heavily weighted towards financials. The idea here is that you are moving out of one high-yield asset class with exposure and into another high-yield asset that lacks exposure.
Junk bonds are straight-up debt that’s issued by the companies in question and are thus tied to the fate of those companies. As junk bonds, they have high risk. The preferred stock funds are, first of all, not linked to oil investments, but to financials, which are doing very well and not as likely to be tainted.
Preferred stock is also not as likely to be susceptible to big moves in the debt markets because they are more a stock-bond hybrid. PFF and PSK also yield 6.9% and 6.1% respectively.
Beware Consumer Discretionary Stocks
You should also keep a close eye on unemployment. Lower oil prices are, on the whole, great for the economy by driving the prices of almost everything lower. The cost of production and transportation go down significantly. However, if oil prices continue to fall, a lot of workers in the energy sector may get laid off. That’s obviously bad.
If that happens, you may want to rotate out of consumer discretionary stocks and ETFs, like the Consumer Discretionary SPDR (ETF) (XLY). If unemployment begins to rise, people will have less money to spend since they’ll be out of work. You could rotate into something like low-cost grocery stores, like Dollar Tree, Inc. (DLTR). If people are out of work, they will have less money to spend, and thus move from standard grocery stores to dollar stores.
Alternatively, you could hedge against just about everything by going long transportation, via the iShares Dow Jones Transport. Avg. (ETF) (IYT). I bought a little of this recently to hedge against my energy holdings. The reason is that with oil prices lower, it means transporting goods is going to cost a lot less, so transport companies should naturally benefit.
As of this writing, Lawrence Meyers was long PFF and IYT. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets at @ichabodscranium.
