For much of 2009, prices in the petroleum complex have been bumping along, trying to form a solid bottom.
Although I can’t tell you exactly when and where the exact bottom will be, the same forces that drove prices sky-high are still lurking in the background, waiting for a chance to reassert themselves.
On the supply side, the cost of finding and producing fossil fuels continues to surge. The easy-to-get-at resources are gone. On the demand side, 3 billion people in the emerging markets are clamoring to drive cars, trucks, buses, tractors and other petroleum-powered machinery.
Until a bottom for energy prices comes more clearly into view, I suggest a cautious approach to the sector. Focus on investments that throw off a generous cash income here and now.
Play it Safe With Master Limited Partnerships (MLPs)
At the head of my energy shopping list these days are publicly traded master limited partnerships (MLPs) that operate pipelines and related infrastructure.
Typically, these toll-taker businesses aren’t directly exposed, in any great degree, to fluctuating prices for oil or natural gas. MLPs collect a fee for transporting the stuff, and sometimes for processing or storing it; they don’t drill for it or peddle it to the end user.
On the other hand, to cover their fixed costs, energy MLPs require a steady volume of goods passing through the pipes. Of late, the economic downturn has crimped sales of refined products (like gasoline and jet fuel). However, pipelines that handle mostly natural gas have continued to thrive. Those are the names I favor for new purchases.
When choosing an MLP, it’s important to look beyond yield alone. Building and maintaining a pipeline costs lots of money, so you want to own partnerships that can tap the debt and equity markets even in today’s unsettled climate. The MLPs on my recommended list are well financed for 2009 and beyond, with ample cash flow to cover quarterly distributions to the unitholders (you and me).
NEXT: Two Top MLPs to Buy Now
Stock #1: Enterprise Products Partners (EPD)
Enterprise Products Partners (EPD) sports a wonderful growth record, having raised its distribution for 18 quarters in a row. The partnership is also yielding an eye-popping 9.2%, mostly tax-deferred (see my note on taxes below).
Normally, I’m wary of the highest yielders, because they’re often facing some kind of financial squeeze. In this case, though, EPD’s yield has blipped for purely technical reasons: The partnership issued $205 million of new units (shares) during the second week of January, depressing the price. EPD traded back down with the market in early March but has since rebounded nicely from $18 to $23.
Stock #2: ONEOK Partners (OKS)
My second pick, ONEOK Partners (OKS), has steadily pumped out cash to Profitable Investing subscribers since my first recommendation in 1994. (Along the way, we’ve rolled up a total return of 382%.)
Unlike EPD, which moves crude oil and petrochemicals as well as natural gas, this MLP focuses exclusively on gas — the safest market niche for a pipeline. Moreover, substantially all the gas gathered, processed, stored and transported by this company comes from the U.S. and Canada, limiting any political risk. Current yield: 9.5%.
Tax Implications of MLPs
Unlike ordinary corporations, master limited partnerships pay no federal income tax. Instead, they pass through essentially all their income and deductions to the partners.
For pipeline partnerships, this means that depreciation deductions shelter a large chunk of your cash payout (usually 80% or more) from current taxation. MLPs do add an element of complexity to your tax return, so you should check with your accountant to see whether the benefits of tax deferral justify the extra paperwork.
For more details on the tax implications of MLPs, visit the Website of the National Association of Publicly Traded Partnerships (www.naptp.org).
