Energy's Best Vehicles for High Income
MLPs and royalty trusts do it differently
By David Sandell
Leeb's Income Performance Letter
The two best ways for investors seeking high current income to invest in the energy sector are through publicly traded master limited partnerships and royalty income trusts. There are similarities and differences between them.
MLPs provide significant tax advantages: Large portions of their distributions are considered returns of capital, and are subtracted form your original cost basis. So the distributions remain mostly untaxed until you sell your shares.
Because of their tax deffered status, MLPs should be held only in taxable accounts. Income is reported with a company-issued K-1 tax form, which involves extra tax-preparation time and expense. But the lofty, tax advantaged income generally more than compensates.
Energy MLPs tend to be involved in transportation and/or infrastructure. They serve essentially as a toll booth operator, receiving a fixed fee for moving a product through pipelines or storing it. Revenues don't fluctuate much with the underlying commodity price. This prevents MLPs from participating in sharp energy-price upturns. But they can raise fees as demand for their services grows, and it protects cash flow on the downside - a boon in tough times.
We hold four MLPs in our Income Portfolio, and all have performed well throughout an historic economic downturn. Their cash distributions rose across the board over the past year, and their fundamental businesses remain strong. The first three are pipeline MLPs, boast near monopolies in their respective geographical regions, and participate in businesses with high barriers to entry from new competition.
Enterprise Products (EPD) provides services involving natural gas, natural gas liquids (NGL), crude oil and petrochemicals. EPD's largest business segment, NGL Pipelines & Services, accounts for 75 percent of revenues by way of 14,000 miles of pipeline. EPD recently raised its quarterly payout. Current yield: 9.5 percent.
Magellan Midstream (MMP) is smaller than Enterprise, but also packs a punch. The company primarily transports refined-petroleum products over 8,500 miles of pipelines, accessing roughly 40 percent of the nation's refinery capacity. Like Enterprise, Magellan recently raised its quarterly dividend. Shares now yield 9 percent.
Penn Virginia Resource (PVR) collects 80 percent of revenue from natural gas operations, and has some exposure to prices that have been weighed down by a supply glut. Management, however, hedges most of this exposure, locking in prices and steadying shareholder cash flows. This MLP yields 15.3 percent and the payout should remain steady for now.
Teekay LNG (TGP) ships liquefied natural gas and other energy products via massive tankers, making it more susceptible to competitive threats than its pipeline brethren. But the company has stayed afloat; it recently completed a public offering to pay off debt, and shares have performed better than those of most other ocean transport companies. Current yield: 13.3 percent.
What to do now: Buy each of these four MLPs for current income and potential price appreciation as economic and market conditions improve.
Royalty income trusts, in contrast to MLPs, finance oil and gas production. The trust owns rights to resource-rich properties and hires an outside company to extract the resources. The trust then collects royalties and makes shareholder distributions. Royalty trusts pay out a high portion of their earnings (such as 90 percent).
Also in contrast to MLPs, trusts' income and payouts are closely linked to the prices of the underlying commodity. U.S. royalty trusts are also subject to diminishing returns because they're not allowed to acquire additional properties. This means less revenue as resources are depleted and production fades. But this decline can be offset by the rising energy prices we anticipate.
The downturn in energy prices inevitably took down shares of royalty trusts. Payouts took a hit too because of the link to commodity prices. The good news is that the time to start buying aggressively may be fast approaching.
Once our economy launches another growth phase, combined with already stronger resource demand from China and the rest of the developing world, we expect energy prices and therefore royalty trust shares and payouts to move markedly higher.
At Calgary, Canada-based Harvest Energy Trust (HTE), upstream production properties are split 70/30 between crude oil and natural gas in western Canada. The company also boasts downstream refining and marketing.
In 2008, Harvest was able to maintain proven reserves, replacing all of the year's production through acquisition and development. Harvest management uses conservative price forecasts that project oil crossing $100 per barrel in 2015, and only reaching $111.90 in 2020. We see prices much higher at that point, presenting considerable upside to the value of Harvest's reserves. Even now, the shares pay a rich 11.4 percent yield.
Under a 2006 proposal, Canadian trusts would be taxed like other corporations (at the 31.5 percent rate) beginning in 2011. Trust shares tumbled when the news hit because this would eliminate their major advantage. But other plans have since surfaced including bringing the tax back to 10 percent and not allowing any more trusts to be created.
Share prices fully reflect the impact of the higher tax rate, and Harvest represents compelling value based on the valuation of its reserves. We recommend that you buy Harvest and we'll add it to the Income Portfolio.
At San Juan Royalty Trust (SJT), the principal asset is a 75 percent net overriding interest in Burlington Resources Oil & Gas properties located in New Mexico. The shareholder payout has slid along with energy prices, with its indicated yield (based on its last payment) standing at only 4.3 percent. But as energy prices move up, payouts will move substantially higher and likely take shares with them.
What to do now: Buy Harvest Energy Trust and San Juan Royalty Trust for the potential of rising income and capital appreciation.
Editor's Note: David Sandell is a contributing editor to Leeb's Income Performance Letter, P.O. Box 97, Williamsport, PA 17703, 1 year, 12 issues, $72. www.leebincomeletter.com.
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