How to Invest in Canadian Energy Stocks via ETFs

Despite facing challenges from government regulations and environmental activism, Canada's publicly traded energy sector remains an attractive investment due to its solid valuations, robust free cash flow, and strong capital return practices through dividends and buybacks.

Much like the appeal surrounding Canada's "big six" banks, ETF issuers in the country have responded to investor interest by offering a range of products tailored to this sector.

In this guide, we'll take a look at the ETFs that offer straightforward, long-only exposure to Canadian energy stocks. We'll skip the "enhanced" options—those incorporating leverage, swaps, inverse exposure, or strategies like covered calls—for a future discussion.

iShares S&P/TSX Capped Energy Index ETF (XEG)

XEG offers a focused approach by isolating the energy stocks from the S&P/TSX Composite Index, specifically tracking the 31 constituents of the S&P/TSX Capped Energy Index.

This ETF is structured with a "capping" mechanism where no single company can exceed more than 25% of the ETF's weight at each rebalance, ensuring no single entity dominates.

A noteworthy aspect of XEG is its free float market cap weighted structure which, despite its broad reach, does not include major midstream energy companies such as Enbridge, TC Energy, and Pembina.

This is because the index specifically targets upstream operators and some integrated firms like Canadian Natural Resources and Suncor, leaving out midstream firms that focus on transportation and storage.

Moreover, companies like Imperial Oil have a reduced weight due to the significant ownership by Exxon Mobil, which limits their free float.

This weighting method reflects in the ETF's portfolio composition but also contributes to its top-heavy nature—Canadian Natural Resources and Suncor alone account for about 50% of the ETF.

While I'm not overly enthusiastic about XEG due to its high expense ratio of 0.6%, excessive concentration in few stocks, and omission of midstream companies, it does offer a substantial 3.9% distribution yield.

This yield, coupled with its inflation sensitivity from a heavy allocation to upstream companies, made it perform well during 2022, marking it as an option for those seeking energy sector exposure with income.

Global X S&P/TSX Capped Energy Index Corporate Class ETF (HXE)

HXE presents a unique and tax-efficient solution for investors looking to capitalize on the Canadian energy sector without the tax drag associated with dividend distributions.

Unlike traditional ETFs that physically hold stocks, HXE operates under a corporate class structure using a total return swap. This derivative instrument engages with a counterparty to replicate the total returns (including dividends reinvested) of the S&P/TSX Capped Energy Index, identical to XEG.

This means that HXE does not distribute dividends directly to its shareholders; rather, any dividends are reinvested and reflected in the ETF's price. This approach not only eliminates the need to reinvest dividends but also enhances tax efficiency, particularly beneficial for holdings in non-registered accounts.

Moreover, HXE charges a significantly lower management expense ratio of 0.27%, compared to XEG's 0.6%. This lower fee structure, combined with the tax advantages of avoiding periodic dividend payouts, makes HXE an attractive, tax-efficient option for exposure to the Canadian energy sector.

BMO Equal Weight Oil & Gas Index ETF (ZEO)

ZEO offers a distinct approach to investing in the Canadian energy sector through its equal weighting strategy, tracked by the Solactive Equal Weight Canada Oil & Gas Index.

This ETF allocates approximately 9% to each of its 11 constituent companies at every rebalance, providing a contrast to the more concentrated XEG which has 50% of its portfolio in 2 stocks.

Notably, ZEO includes significant midstream coverage with positions in all four major pipelines—Enbridge, TC Energy, Pembina, and Keyera—alongside a variety of large integrated energy companies and explorers & producers.

Like its counterpart XEG, ZEO also delivers a solid distribution yield, standing at 4.07% and distributed quarterly. This yield is attractive for income-focused investors.

However, despite its diversified approach, ZEO's cost remains a concern. With an expense ratio of 0.61%, it's on the higher side for what essentially amounts to equal weighting a small basket of stocks.

Given today's accessibility to commission-free trading platforms like Wealthsimple, investors could feasibly replicate this ETF's holdings without incurring ongoing management fees.

Global X Pipelines & Energy Services Index ETF (PPLN)

Upstream companies, like those heavily featured in ETFs such as XEG, are primarily involved in the exploration and production of oil. However, the midstream sector—comprising entities that handle the transportation, storage, and marketing of oil—plays a pivotal role in the energy supply chain.

PPLN tracks the Solactive Pipelines & Energy Services Index, capturing not only major pipeline companies like Enbridge, TC Energy, Pembina, and Keyera, but also firms involved in additional midstream activities such as AltaGas, Parkland Fuel Corp, and Gibson Energy.

This inclusion broadens the scope of the ETF, providing a more comprehensive look at the energy infrastructure and services necessary to move and process oil from the field to the end consumer.

Unlike the HXE, PPLN is not a corporate class ETF using swaps, which means it distributes actual dividends. Currently, PPLN offers a quarterly dividend, which results in an annual yield of 3.65%.

However, potential investors should be aware of the relatively high expense ratio of 0.74%, which is higher than the previous ETFs highlighted.