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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on September 3, 2022.

Adams Natural Resources Fund (NYSE: PEO) is a rather unique energy fund. Lots of closed funds that focus on energy/infrastructure will incorporate significant exposure to MLPs and midstream companies. In the case of PEOs, they invest the majority of their exposure in oil majors. They also have some exposure to the more volatile exploration and production companies.

Another somewhat similar fund that came to mind is BlackRock Energy and Resources (BGR). They share a significant overlap in their major allocations, apparently focusing on a few of the most qualified companies. Interestingly, they both have a significant weighting in their top holdings. PEO’s top ten account for 67.5% of the fund. BGR’s top ten is an almost identical concentration at ~68% of the total portfolio.

Funds also share another characteristic; these are the two funds that trade at deep discounts. Their distribution policy and investment strategy is where they start to diverge a bit. Beyond just investing in natural resource companies, BGR employs a call writing strategy in its portfolio.

My personal view is that I’m more bullish on short term energy, but longer term I’m less bullish. Renewables will become more viable every day as costs come down and demand for fossil fuels is reduced. That’s not to say that oil and natural gas won’t play a role; I believe they will be there forever. The growth of renewables is outpacing fossil fuels, and this faster rate of growth is expected to continue.

The companies that PEO invests in are some of the largest that I believe will survive and have the ability to transition with the industry. This makes them very attractive as an investment option.

The basics

  • Z-score over 1 year: 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 deliver superior returns over time by capitalizing on the long-term demand for energy and materials. The Fund invests in energy and natural resources stocks and seeks to generate returns above its benchmark as well as regularly distributing dividend income and capital gains to shareholders.”

Similar to the other Adams fund, Adams Diversified Equity Fund (ADX), PEO has an incredibly long history. The date of creation dates back to 1929. PEO also changed its name when ADX did. Previously, the fund was known as Petroleum & Resources Corporation.

Another similarity with ADX is that the fund uses no leverage. This can be positive, especially when your underlying investments are volatile enough.

The fund expense ratio is incredibly low for the closed-end fund space – another feature present in ADX. However, it is still at the high end if competing with an ETF. In 2021, the average expense ratio for an ETF was 0.49%.

Performance – Competitive against its benchmarks

Energy has been an incredibly volatile sector to invest in. They are cyclical stocks that experience ups and downs. A few years ago we saw negative oil prices and then we started to see some of the higher prices earlier this year. Now we have backtracked significantly.

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Y-Charts

Where the price may go next, no one knows. But I suspect it continues to be quite volatile. From 2015 to 2020, there has been a lot of pain in the sector. However, it seems companies have done better to focus on strengthening their balance sheets and rewarding shareholders now that they can.

PEO’s longer-term results reflect this, with rather poor long-term results, but more recently performance has been much better. They use the S&P 500 Energy Sector Index and the Materials Sector Index as benchmarks. We can see the two periods where PEO outperformed its benchmark, achieving its goal of providing “outperforming returns”.

PEO annualized returns

PEO Annualized Returns (Adams Fund)

These better results for the sector seemed to attract the attention of investors. The PEO is trading at a significant discount, but still above the average discount over a decade. Nonetheless, I would say that the fund is still attractively discounted and expanding the discount from this level to the average would not be too painful.

I would be more concerned about the global energy market which is already in a massive run. If we go into anything other than a mild recession, these are the types of stocks that will be hit hard.

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Data by YCharts

By comparing the results between PEO and BGR, we can see that PEO has taken quite a significant lead over the past decade. This had really accelerated after the 2020 low. One reason for this is that BGR’s options strategy during a bull market will dampen its performance. The position will either be capped, limiting the upside, or the fund will have to close the position, generating losses.

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Y-Charts

Covered call writing strategies may work best in a flat market. It can provide some cover when there are shallow declines.

Distribution – 6% minimum policy

Another similarity between PEO and ADX is their 6% minimum payout policy. These funds pay a small regular quarterly distribution. A big end-of-year special then completes everything to reach this minimum level.

PEO Distribution History

PEO Distribution History (Adams Fund)

The last regular distribution is $0.10. They have been paying this since 2009. Since they adjust year-end and pay a minimum amount throughout the year, it is quite easy for them to keep the regular rate steady.

In 2021, they didn’t pay a massive year-end that some investors might have been looking for. The reason for this is that it looks like they haven’t realized the majority of their portfolio. Instead, they kept their gains mostly in the form of unrealized appreciation. This way, they would not be required to make any large payment.

PEO semi-annual report

Semi-Annual PEO Report (Adams Fund)

Based on what we see above, they seem set to offer a longer year-end for 2022. That would be the assumption at this point, with the fund making more mid-term gains. Additionally, the fund looks like net investment income should also exceed last year’s NII.

It’s still a little early to guess, though. They publish quarterly reports, so when we see the third quarter we will have a better idea of ​​what the fund might be able to pay.

For tax purposes, the majority of distributions in 2021 were investment income. A significant portion has also been characterized as short-term capital gains.

PEO Tax Character 2021

2021 PEO Tax Character (Adams Fund)

77.5% of the distribution was considered eligible dividend income. This would have helped make it a little more taxing for investors. Tax character can change drastically from year to year, so this is something that will always need to be monitored.

PEO Portfolio

Most of PEO’s portfolio is invested in integrated oil majors, as mentioned above. E&P also makes a significant allocation. We are then less exposed to the chemicals, refining and marketing, equipment and services, and storage and transportation industries.

PEO Industry Weighting

PEO Industry Weighting (Adams Fund)

There is a bit of exposure to each industry. When you look at integrated oil areas, you basically get exposure to each of these smaller subset industries. Overall, I think this creates a fairly balanced approach to “natural resource” investing.

On the other hand, I think you run some concentration risk here, which is not usually said about a CEF as they naturally provide exposure to different companies. We made a point that the top ten above are very focused, but two of the most important positions here stand out the most. The first two here represent 35.5% of the entire portfolio.

Top 10 PEOs

PEO Top Ten (Adams Fund)

Fortunately, Exxon Mobil (XOM) and Chevron (CVX) are in this basket of major oil players. I don’t see these companies leaving any time soon, as they can transition as needed and adapt. Both have already put capital into working on renewable and low-carbon projects, although they aren’t the most vocal about those projects.

Both of these companies have also been rewarding their shareholders through growing dividends for decades. They rode through negative oil prices without a dividend cut.

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Y-Charts

Although some point out that the dividends were actually paid by increasing debt. If they didn’t pay the dividends, they could have avoided going into debt in recent years. Now it looks like they are paying off the debt and heading in the right direction.

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Y-Charts

Conclusion

PEO is an interesting name to play the energy space. You get a set of mostly oil majors, which is a change from other CEFs that mostly offer midstream/infrastructure exposure. The payout policy is likely to appeal to a rather narrow group of investors, similar to what we saw with ADX. High concentrations in the few largest holdings could make it easier for investors to replicate PEO’s exposure. At the same time, they have shown that they are also capable of obtaining respectable returns through their management. For some investors, this might be enough for this fund to be the “set and forget” of their energy exposure.

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