Following a strong second quarter in which it looked like the energy sector might finally be on the mend, the third quarter turned out to be abysmal. West Texas Intermediate (WTI) began the quarter near $60 a barrel, but the benchmark oil price plunged 24% in Q3, crushing the energy sector. Natural gas prices fared better, but still dropped 12% during the third quarter, and have been in the doldrums now for nearly as long as oil prices.

The Energy Select Sector SPDR ETF (XLE), which is heavily concentrated in giants like ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX) and Schlumberger (NYSE: SLB), lost 18.4% for the quarter. The SPDR S&P Oil and Gas Exploration and Production ETF (NYSE: XOP), which is more representative of the smaller-cap drillers, dropped 28.6% in Q3.

The decline was broad-based across the energy space. Of the 421 publicly traded energy equities in my database, only 24 — 5.7% — registered a positive total return for the quarter. The average energy stock lost 29.3%.

Here are the top 10 energy performers sorted in order of descending Q3 total return:

• EV = Enterprise value in billions as of Oct. 23
• Q3 = Q3 total return calculated from the close on June 30 to the close on Sept. 30, adjusted for dividends paid during the quarter
• YTD = Year-to-date total return

Several sub-sectors are represented in the top 10, but refiners account for fully half the list. The refining sector has excelled throughout this energy bear market, but now faces a significant risk of contracting margins.

The 10 worst performers lost more than 70% each during the quarter. This doghouse featured highly leveraged oil and gas producers and a fracking sand miner:

Even though the bear market in the energy sector is now over a year old, there are still some 80 energy stocks in positive territory for 2015. Here are the top 10 for the year through Q3:

With the exception of the refiners, the sector looks oversold. Join us at The Energy Strategist for our most up-to-date recommendations on weathering the rest of this storm, and on making sure your portfolio is positioned to benefit from the eventual recovery.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Kinder Morgan’s High-Yield Gambit       

The midstream earnings season has started with a bang and lots of whimpers.

The bang was from the dent lower energy prices left on Kinder Morgan’s (NYSE: KMI) dividend growth plans, now down to a range of 6% to 10% for 2016, from the prior promise of 10% for years to come. Whimpering can still be heard with Kinder Morgan’s share price down 12% in the three trading sessions since it backtracked on the dividend and released quarterly results widely described as disappointing.

Perhaps the analysts were too aggressive with their estimates, but no one who’s paid attention to the energy sector over the last year should have been surprised.

Third-quarter cash earnings of Kinder Morgan’s operating segments were down 1% year-over-year, hardly a disaster given the 50% drop in crude prices over that time span, an even greater decline in the price of natural gas liquids and a discount approaching 40% on natural gas.

It helped, of course, that Kinder Morgan has in the last year completed projects costing more than $2 billion, in addition to spending $3 billion on an acquisition. That spending helped put the company $42.5 billion in debt, though Kinder’s buyout of its MLP affiliates last year is the main reason its debt now amounts to a hefty 5.8 times recent annual EBITDA (earnings before interest, taxes, depreciation and amortization.)

On the other hand, Kinder Morgan is saving almost $700 million this year in reduced payouts after taking out its higher-yielding MLPs, and more than $400 million in cash taxes through the first nine months of the year, also as a result of the consolidation.

That’s how it’s affording this year’s 15% dividend increase, a promise it now plans to keep with $300 million in cash earnings to spare, down from the $650 million cushion projected at the outset of the year.

That means distributable cash flow will undershoot the original target by 7% amid the dramatic decline in energy prices since that plan was made. The shortfall makes plain the rationale for slowing next year’s dividend growth; the company doesn’t want payouts to exceed distributable cash flow.

We’re on record in highlighting Kinder Morgan’s hefty debt load and criticizing its ill-timed Bakken acquisition earlier this year.

But the 7% shortfall in cash flow relative to a budget drawn up a year ago is a sign of resilience rather than terminal weakness, given the extent of the slump in energy prices.

Those prices are now at levels guaranteeing domestic production will decline over time, even as demand continues to grow. And it is demand that can’t be met over the long haul without a thriving midstream sector.

As for the $1.6 billion mandatory convertible preferred offering priced today, there’s a lot of confusion out there about the high yield and Kinder Morgan’s reasons for pursuing the deal.

The offering priced at an effective yield a shade under 10%, so in effect the company is offering investors in these hybrid securities an incremental 2.6% of annual yield over the common dividend for the next three years in exchange for foregoing the benefit of capital appreciation from the first 17.5% regained by KMI’s stock over that time. (There’s also a floor conversion price of $9.65 per share, which is not a very valuable put option.)

Buyers of the preferreds are betting that KMI shares will appreciate less than 17% if they appreciate at all over the issue’s three-year term, justifying their choice of higher yield with reduced capital appreciation prospects. One way to capture the yield advantage while hedging the appreciation risk is to sell KMI common short while buying the preferreds, a strategy that very likely contributed to the recent price drop.

Kinder Morgan, meanwhile, has solved its equity financing needs for the next nine months or so, while limiting the cost of issuing equity before a share price recovery. It’s clearly able to issue much cheaper debt, but is constrained by the imperative to preserve its investment-grade credit rating and the need to work off the leverage added to buy out its MLP affiliates last year.

This looks like a fair deal all around, though we still prefer the common to the preferred given the decent likelihood of a significantly higher share price in three years.

The common shares’ current 7.4% yield undervalues Kinder Morgan’s long-term growth opportunities and overemphasizes  the dimmed near-term outlook. We’d be willing to clip the coupons for now while waiting on the capital gains, and are upgrading KMI to a Buy below $35.

— Igor Greenwald