Oil stocks may be appropriate for retirees depending on the individual risk tolerance of the investor and the size and structure of his portfolio.
Many oil stocks pay decent dividends, which can provide an income stream for retirees, reports the Investopedia.
However, oil stocks have substantial volatility and the possibility of drawdowns that retirees must be able to weather.
Certain types of oil investments such as master limited partnerships (MLPs) may offer significant estate planning benefits for more sophisticated investors.
Further, despite their volatility, oil stocks can provide diversification for a portfolio.
The following are the main considerations for retirees considering investing in oil stocks.
PRICE VOLATILITY
The performance of oil stocks is highly correlated with the price of crude oil.
If prices for crude oil go up, the share prices for oil stocks follow.
The reverse is true as well.
Crude oil is notorious for making large price swings.
The drop in crude oil prices in 2014 and 2015 serves as an example.
Crude oil was trading over $105 a barrel in the summer of 2014.
Due to supply glut and other economic factors, the price dropped substantially, to as low as $42 in 2015.
Natural gas also had a similar drop during this time period.
Oil stocks got beat up along with the price of crude oil.
Companies cannot earn as much revenue from the sale of their products if commodity energy prices are low.
This hurts their performance, and stock prices drop as a result.
As an example, Chevron Corporation (NYSE: CVX) is a major integrated oil and gas producer with a market cap of $168 billion as of October 2015.
Chevron’s revenues have gone down since 2012.
The company earned revenue of $211 billion in 2013 and $191 billion in 2014, a drop of 9.4 per cent.
The stock price has followed suit. Shares were trading over $130 in July 2014 but fell to below $75 a share in August 2015.
Chevron’s stock has a beta of 1.14, indicating it is more volatile than the overall market.
This price volatility in oil may be difficult for some retirees to handle.
However, some retirees may be well diversified with decent-sized portfolios.
In this case, an allocation to oil stocks might be appropriate. The higher volatility of oil stocks may be offset by less volatile investments in bonds or other fixed-income securities.
DIVIDENDS
Many oil and gas stocks pay attractive dividends.
The dividends can provide a stream of income for retirees that can cover a portion of their living expenses in retirement.
However, dividends have risks associated with them. Experts note companies that pay dividends often have lower long-term potential for growth.
While the dividend payments might appear attractive, there is often less appreciation in the share price over time.
Thus, a retiree may miss out on wealth appreciation by focusing only on dividend-paying stocks.
There is also no guarantee companies will be able to pay dividends indefinitely.
Retirees should understand the risk of a possible dividend cut. This is especially true for oil and gas stocks.
If companies are earning less revenue from the sale of their commodities, they may not be able to fund their dividends.
A number of high-profile companies in the oil and gas sector have been forced to cut their dividends due to the crude oil price drop.
Seadrill, Ltd. (NYSE: SDRL) is a major provider of drilling services.
It was a very popular stock due to its commitment to strong dividend growth.
It paid one of the highest dividends in the sector, often over 10 per cent.
Many income investors were attracted to the high dividends. The company encountered difficulties due to low crude oil prices.
It made numerous assertions to investors that the dividend payments were safe despite reduced demand for its drilling rigs and a very high debt load.
However, Seadrill was forced to cut its dividend in November 2014.
The share price was trading at over $40 a share in August 2014, and it fell to around $8 by October 2015, for a drop of 80 per cent in slightly over a year.
Investors in the company lost out not only on the future payment of dividends but also a significant amount of the value of their investments because of the drop in share price.
Retirees may be able to avoid this scenario by doing due diligence on a company’s financial ability to pay dividends.
Many larger oil companies do not appear to have as high of a risk for a dividend cut.
Still, the financial condition of an oil company can change rapidly along with the price of crude oil.
Retirees may need to closely monitor their portfolios if they include oil stocks.
MASTER LIMITED PARTNERSHIPS
MLPs may be an option for retirees due to their strong dividend yields, significant tax advantages and estate planning benefits.
MLPs are unique investment vehicles that are popular in the oil and gas sector.
Distributions from MLPs are tax-deferred as long as they are not held in an individual retirement account (IRA).
According to the Internal Revenue Service (IRS), MLPs are pass-through entities.
This means distributions are not taxed at the corporate level as with many companies.
Further, distributions from an MLP are not taxed when they are received by the investor, unlike dividends.
Distributions are considered to be a reduction for the cost basis in the investment.
Taxes are only due once the interest in the MLP is sold.
MLPs also have significant benefits for estate planning.
If an interest in an MLP is passed to heirs, the heirs inherit the interest with a stepped-up cost basis.
They could sell the interest in the MLP and not owe any taxes.
The heirs can avoid paying taxes on an inherited MLP interest, which can serve as a significant tax-free transfer of wealth.
While MLPs offer definite advantages, they are not without risk.
The Alerian MLP Index, which tracks large- and mid-cap MLPs, fell around 40 per cent between September 2014 and September 2015.
Thus, MLPs have the same exposure to the price volatility of crude oil.
However, MLPs are intended to be long-term investments.
The tax and estate benefits may outweigh the price volatility for retirees in the long run.
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