The world needs energy to function. The oil and gas industry has fascinated investors for several decades. I think this is due to the thrill of the next exploration results or an oil boom that is driving stocks to record highs.

The oil and gas industry is typically divided into three activities: upstream, midstream and downstream. Companies that are “integrated” take an active part in all three activities.

Upstream: This term stands for all activities related to exploration and production. This is usually the phase when the price of raw materials is most important. Companies make their financial projections based on a specific price (or cost) per barrel. They then decide whether or not to drill, based on the likelihood of a profitable operation.

Midstream: Midstream activities include the processing, storage and transportation of oil and gas and their by-products. Here you can find pipeline companies. Transportation and storage activities tend to be more stable as they tend to enter into long-term contracts with manufacturers.

Downstream: This is the final step in the process, including refining (for example to produce gasoline) and marketing the product (selling to the end customer). Think not just of gasoline, but of all other modified products such as liquefied natural gas, heating oil, synthetic rubber, plastics, lubricants, antifreeze, fertilizers and pesticides.

Subsectors (industries)

Greatest strengths

Oil and gas stocks will stir passions and attract many investors during bull markets. With economic growth, the demand for such products increases accordingly. Commodity prices are rising, profits are skyrocketing, and dividends are generous. The problem is, it rarely stays that way.

The energy sector can make high returns on your portfolio, but you need to monitor this sector closely (and hopefully know what you are doing). If you can select stocks during an oil bankruptcy (as was the case back in March and April 2020), double-digit (sometimes triple-digit) returns are shown. Since we are not in the “buy and sell fast” strategy, we at DSR rarely like energy stocks. They usually make unreliable dividend producers.

Biggest weaknesses

The energy sector is very volatile and cyclical. This isn’t exactly the best place to pick dividend producers. Many companies will attract investors with their high returns and generous promises, but they will ultimately fail their shareholders. I’ve heard the best and worst stories in this sector. So it is important that you do your homework before investing in the energy sector.

The main problem in this sector is that it is capital intensive and profits are often dependent on commodity prices. Companies have little or no control over the prices they get for their oil or natural gas. Therefore, they have to spend billions on projects and hope that the final price will stay interesting for several years.

Vertically integrated companies (upstream, midstream, and downstream) tend to keep their dividend payments on no matter what, but it’s still a risky business. For example, BP (BP) had to cut its dividend after a major oil spill. Royal Dutch Shell (RDS.A or RDS.B) and Suncor (SU.TO / SU) also reduced their distribution after the oil debacle in 2020.

As technology advances, our energy needs stagnate while our production capacity improves. In other words, don’t expect natural gas prices to go up anytime soon. All of the factors are combined to keep it low.

How to make the most of it

The energy sector is the most cyclical of all. If you’re brave enough to ride a roller coaster, every few years you can buy stocks at heavily depreciated prices. If, like us, you’d rather focus on a dividend growth investment strategy, you need to be incredibly selective before investing a dime in this sector.

I prefer pipelines (midstream industry) as the most interesting opportunities in the energy sector. Pipelines are capital intensive and exposed to regulators and potential oil spills, but they also act as toll roads. The world needs energy and pipelines deliver it.

Favorite selection

TC Energy (TRP)

  • Market capitalization: 53B
  • Yield: 5.80%
  • Revenue growth (5 years, annualized): 5.41%
  • EPS growth rate (5 years, annualized): 11.66%
  • Dividend growth rate (5 years, annualized): 9.34%
Source: TC Energy

Business model

TC Energy is an energy infrastructure company comprised of pipeline and power generation assets in Canada, the United States, and Mexico. TC Energy’s pipeline network consists of over 92,600 kilometers of natural gas pipeline and 4,900 kilometers of the Keystone pipeline system. The company owns or is involved in 11 power generation plants with a capacity of 6,600 megawatts.

Investment thesis

TRP is using large amounts of capital to drive its growth in the years to come. The acquisition of the Columbia pipeline and expansion into Mexico are just one example of what TRP is expecting. The company will benefit from Mexico’s economic growth (once we get out of the coronavirus). I prefer ENB because of a higher dividend yield and greater commitment to dividend growth, but TRP is definitely a good candidate for long-term investments. The company transports 25% of all natural gas in North America and expects to invest heavily in its pipeline network in the coming years. As with ENB, make sure you keep track of TRP’s rising debt. The company remains focused on rewarding shareholders with generous dividend increases for years to come.

In January, the new Biden administration rejected the Keystone XL project, causing investors to doubt TC. How has that affected the company? Is the TRP Dividend Still Safe? Does it still fit in your portfolio? I checked the situation in the video below.

Enbridge (ENB)

  • Market capitalization: 88B
  • Yield: 7.43%
  • Revenue growth (5 years, annualized): 5.87%
  • EPS growth rate (5 years, annualized): 13.93%
  • Dividend growth rate (5 years, annualized): 16.09%
Source: Enbridge

Business model

Enbridge is a power generation, distribution, and transportation company based in the United States and Canada. The pipeline network consists of the Canadian mainline system, regional oil sands pipelines and natural gas pipelines. The company also owns and operates a regulated natural gas supplier and Canada’s largest natural gas distribution company. In addition, Enbridge generates renewable and alternative energy with an output of 2,000 megawatts.

Investment thesis

ENB customers conclude transport contracts with a term of 20 to 25 years. It is already well positioned to benefit from Canada’s oil sands (as its main line covers 70% of Canada’s pipeline network). As production increases, the need for ENB pipelines remains high. After the merger with Spectra, around a third of the business model will come from natural gas transport. Enbridge has a handful of projects on the table or under development. In particular, it has to deal with the regulatory authorities in its lines 3 and 5 projects. Both projects are developing slowly but surely. The cancellation of the Keystone XL pipeline (TC Energy) secures ENB more business for its liquid pipelines. ENB now has a “greener” focus with investments in renewable energies. The stock offers a return of over 7%, making it a strong candidate for any retirement portfolio. The dividend is safe when you factor in ENB’s distributable cash flows.

I also made a video about Enbridge on YouTube. You can refer to it for my full analysis of the business and its dividend security.

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