Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published for members of the CEF/ETF Income Laboratory on September 3, 2022.
Adams Natural Resources Fund (NYSE:PEO) is a rather unique energy fund. Many of the closed Funds focused on energy/infrastructure will include significant exposure to MLPs and midstream companies. In the case of PEO, they invest much of their exposure in the oil majors. They also have some exposure to the more volatile exploration and production companies.
Another fund that first came to mind that is somewhat similar is BlackRock Energy and Resources (BGR). They have significant overlap in their top allocations and appear to be concentrated in a few of the highest quality companies. Interestingly, both actually have a significant weighting of their top holdings. The top ten PEOs make up 67.5% of the fund. The BGR top ten is an almost identical concentration of ~68% of the total portfolio.
The funds have one more feature in common; that is, both funds are trading at deep discounts. Their allocation policies and investment strategy is where they start to diverge a bit. BGR not only invests in resource companies, but uses a call-writing strategy in its portfolio.
My personal view is that I’m more bullish on energy in the short term, but less bullish on the longer term. Renewable energy is becoming more viable every day as costs come down and demand for fossil fuels falls. That’s not to say that oil and natural gas don’t play a role; I believe they will be there forever. Renewable growth is outpacing fossil fuels, and this faster pace of growth will continue.
The companies that PEO invests in are some of the largest that I believe will survive and have the ability to transform along with the industry. This makes them quite attractive as an investment opportunity.
- 1-year z-score: 0.76
- Discount: -13.26%
- Distribution yield: 1.86% (regular distribution only)
- Expense ratio: 0.63%
- Leverage: N/A
- Assets under management: $603 million
- Structure: Perpetual
PEO “seeks to generate superior returns over time by capitalizing on long-term demand for energy and materials. The fund invests in energy and commodity stocks and aims to deliver returns in excess of its benchmark and to consistently return dividend income and capital gains to shareholders.”
Much like Adams’ other fund, the Adams Diversified Equity Fund (ADX), PEO has an incredibly long history. The founding date goes back to 1929. PEO also went through a name change when ADX had. The fund was formerly known as Petroleum & Resources Corporation.
Another similarity to the ADX is that the fund does not use leverage. That can be a positive, especially if your underlying assets are volatile enough.
The fund’s expense ratio is incredibly low for the closed-end fund space – another feature present in the ADX. However, it’s still on the high end when competing with an ETF. In 2021, the average expense ratio for an ETF was 0.49%.
Performance – competitive to its benchmarks
Energy is an incredibly volatile sector to invest in. They are cyclical stocks and go through booms and busts. A few years ago we saw negative oil prices, and then earlier this year we started seeing some of the highest prices. Now we’re back down significantly.
Where the price may go next, no one knows. But I would guess that it remains quite volatile. From 2015 to 2020, there was a lot of pain in the industry. However, it seems that companies are better off focusing on strengthening their balance sheets and rewarding shareholders when they can.
The longer-term results for PEO reflect this, with the longer-term results being on the poor side, but lately the performance has been looking much better. They use the S&P 500 Energy Sector Index and the Materials Sector Index as benchmarks. We can see that in both periods, PEO has outperformed its benchmark and met its goal of delivering “superior returns”.
These better results for the sector seem to have caught investors’ attention. PEO is trading at a deep discount, but still higher than the decade-long average discount. Still, I’d say the fund is still attractively discounted and extending the discounting from this level back to average wouldn’t be too painful.
I’d be more concerned that the entire energy market is already on a massive run. When we enter anything more than a mild recession, these are the types of stocks that get hit significantly.
If we compare the results between PEO and BGR, we can see that PEO has progressed quite significantly over the past decade. It had really recovered from the bottom of 2020. One of the reasons for this is that BGR’s options strategy will weigh on its performance during a bull market. The position is either exited, limiting upside potential, or the fund is forced to close the position, resulting in losses.
Covered call writing strategies can work best in a flat market. It can provide some protection when there are shallow slopes.
Distribution – 6% minimum policy
Another similarity between PEO and ADX is their minimum payout policy of 6%. These funds pay out a small regular quarterly distribution. A big year-end special then rounds it all off to reach that minimum level.
The latest regular distribution is $0.10. They’ve been paying for this since 2009. Since they adjust the year-end and pay out a minimal amount throughout the year, it’s pretty easy for them to keep the regular rate stable.
In 2021, they didn’t pay a massive year-end that some investors might have been waiting for. The reason is that they don’t seem to have realized most of their portfolio. Instead, they kept most of their gains as unrealized appreciation. That way, they wouldn’t have to make any significant payments.
Based on what we see above, they should deliver a bigger year-end for 2022. That would be the assumption at that point, with the fund realizing more gains at that point. In addition, the fund’s net investment income looks set to beat last year’s NII as well.
However, it’s still a little early to make a guess. They release quarterly reports so in the third quarter we’ll have a better idea of what the fund might be able to pay out.
For tax purposes, the majority of distributions in 2021 were capital gains. A significant portion has also been characterized as short-term capital gains.
77.5% of the distribution was considered qualifying dividend income. That would have helped make it a little more tax-friendly for investors. The tax character can change drastically from year to year and therefore must always be monitored.
As noted above, the bulk of PEO’s portfolio is invested in integrated oil companies. E&P also makes a sizeable allocation. We then get a smaller exposure to chemicals, refining and marketing, equipment and services, and the storage and transportation industries.
There is a bit of contact with each industry. Essentially, if you look at the integrated oil activities, you’re getting exposure to each of these smaller sub-sectors. Overall, I think it creates a fairly balanced approach to “natural resource” investing.
On the other hand, I think you are running some concentration risk here, which is not generally said about a CEF as it obviously offers exposure to different companies. We did note that the top ten above are highly concentrated, but two of the largest positions here are most notable. The top 2 account for 35.5% of the total portfolio.
Fortunately, Exxon Mobil (XOM) and Chevron (CVX) are in this basket of oil majors. I don’t see these companies going anywhere anytime soon as they can switch and adapt as needed. Both have already put some capital into renewable and lower-carbon projects, though they’re not the most energetic on those projects.
Both companies have also been rewarding their shareholders with growing dividends for decades. They did it without cutting the dividend due to negative oil prices.
However, some would point out that the dividends were actually paid for by taking on debt. If they hadn’t paid the dividends, they could have avoided incurring debt in recent years. Now they appear to be paying off the debt and heading in the right direction.
PEO is an interesting name to play up the energy space. You get a package of mostly oil majors, which is a change from other CEFs that offer mostly midstream/infrastructure exposure. The distribution policy should appeal to a rather small group of investors, similar to what we saw with the ADX. The high concentrations in the top few holdings could make it easier for investors to replicate PEO exposure. At the same time, they have shown that their management has also enabled them to achieve respectable returns. For some investors, this could be enough to make this fund the “set and forget” of their energy exposure.