The Adams Natural Resources Fund (PEO) invests across global energy and materials sector stocks through a closed-end fund structure. This is a segment that has gained momentum considering rising commodity prices driving an impressive 45% return for PEO over the past year. Indeed, the attraction in the fund is its unique dual-sector strategy among CEFs with a long history of solid performance. Income investors will also find PEO’s distribution policy compelling considering the fund targets a minimum 6% yield through a quarterly payout. We believe energy prices have more upside this year in the current macro environment and PEO is a good option to capture long-term strategic exposure.
What is the PEO Fund?
According to the fund objective, PEO seeks to deliver superior returns by capitalizing on the long-term demand for natural resources while consistently distributing dividend income and capital gains to shareholders. As an actively managed fund, PEO is not intended to track any index, although Adams Funds uses a composite benchmark between 70% in the S&P Energy Index and 30% in the S&P Materials Index to gauge its performance.
This is nearly in line with the fund’s current sector exposure which is currently around 75% in energy and 25% in materials sector stocks, although there is some flexibility for these levels to vary the allocations. We can proxy the performance benchmark through the Energy Select Sector SPDR ETF (XLE) and Materials Select Sector SPDR ETF (XLB) for reference purposes.
Exxon Mobil Corp. (XOM), Chevron Corp (CVX), and ConocoPhillips (COP) together represent 38% of the fund’s weighting, highlighting the clear tilt towards energy. While this is relatively top-heavy and concentrated for most funds, consider that XOM and CVX alone represent 44% of the XLE ETF. PEO’s largest materials sector holding in Linde Plc (LIN) with a 4% weighting compares to a 17% position for the stock within the XLB ETF. Overall, we can say that PEO holdings include some of the most important U.S. listed companies in energy and materials although the portfolio composition is at the discretion of the fund’s portfolio management team.
It follows that PEO with its tilt towards energy but balanced with materials sector stocks should outperform XLE in a scenario where XLB is leading higher. That’s the case with a 3-year lookback period where PEO has returned 36% which compares to a 21% gain in XLE and 58% return from XLB.
In other words, we can expect PEO’s performance to end up somewhere in between an energy and materials sector benchmark over any particular time frame. The fund’s performance history is consistent with this strategy. Favorably, with the strength in energy stocks this year, PEO is up 13.5% this year which compares to a 21% gain in XLE and while XLB is down 9%.
So the key point here is that PEO is not necessarily intended to “beat” the energy or materials sector but instead offer diversified exposure to both. There is an understanding that commodity producers including oil, metals, chemicals as real-assets stand to benefit from inflationary trends as a long-term tailwind. This scenario is part of the bullish case for the fund right now.
It’s also worth pointing out that PEO has historically traded at a discount to NAV which is normal for equity CEFs in the category. The current spread at -14% is just around the 3-year and 5-year average for the fund. There is a thought that continued momentum in natural resources can support a narrowing of the discount which can add an incremental return to shareholders.
We mentioned PEO targets a 6% distribution yield through a quarterly payout. The unique aspect of this policy is the consistent $0.10 dividend for the first 3 quarters of the year, followed by a larger variable amount in Q4. or 2021, PEO distributed a total of $0.91 including $0.61 as the final Q4 amount. Notably, the distributions have historically been primarily based on the underlying portfolio dividend income or long-term capital gains. 2018 was an exception where the fund did utilize a smaller portion of the payout as a return of capital (ROC).
Since 2017, the distributions have ranged from a high of $1.18 to as low as $0.73 recognizing that these amounts translated to an annual distribution rate above 6% on a trailing twelve months basis depending on the stock price. With shares currently around $18.50, the stated yield on the stock on a trailing twelve months basis is 4.9%. We can estimate that at a constant share price from the current level through the end of 2022, PEO shareholders can expect at least $1.11 in total distributions this year, to maintain a rate above 6%.
PEO Price Forecast
The latest market development has been the concerning turn of events in Western Europe. Headlines of a Russian invasion into Ukraine were enough to lift Brent crude oil sharply higher and above the key $100 per barrel price level for the first time since 2014. This comes onto what was already solid momentum in energy prices amid the post-pandemic recovery demand into tight supply conditions.
Further disruption to global supply chains or even sanctions on Russia’s oil exports can drive energy prices significantly higher. The same dynamic is at play with materials with metals prices, in particular, getting a bid. The backdrop here is a strong operating environment for natural resources and commodity producers that benefit from higher revenues, cash flow, and earnings.
PEO does a good job of capturing these high-level trends in natural resources and we see upside for the fund going forward in a bullish environment for energy sector stocks. The 6% distribution yield makes it a compelling income vehicle that is unique among non-leveraged and long-only equity closed-end funds. While the PEO’s expense ratio at 0.88% is higher than most ETFs, the level is well below the average for equity CEFs and we believe the rate is justified considering the strong historical performance.
In terms of risks, it’s clear that a sharp reversal in energy prices or weakness in the materials sector would be bearish for PEO’s underlying holdings. One potential headwind to consider could be the impact of weaker demand if the geopolitical tensions intensify representing a hit to economic activity and the broader macro outlook. We expect volatility to continue for equities as an asset class overall.