Energy stocks are looking pretty attractive if you believe that oil prices -- down from $145 per barrel in July to $41 lately -- will soon take off on a new and extended upturn. The 32% run-up in oil prices between December 23 and January 9 may be an indication that oil's slump is over. (Then again, maybe it's not.) Fortunately, you don't need to know which direction oil prices are headed to make money now from one of the best buys in the sector: partnerships that invest in pipelines and storage facilities for oil and gas.
Shares of these partnerships are offering rich current yields -- 8% to 10% for our favorites -- and the most stable of these firms are unlikely to cut their payouts. That's because the profits of many pipeline operators aren't tied to the prices of oil and gas. Instead, operators make their money by charging set fees for transporting energy products from one place to another and then storing them. Many have local or regional monopolies and stable cash flows from long-term contracts.
The rates that pipeline operators charge their customers are federally regulated and include generous inflation adjustments. So-called take-or-pay contracts, which require payment whether or not the pipeline capacity is used, are not uncommon. "It's a great business model, and almost every stock is selling at half price," says Morningstar analyst Jason Stevens.
For years, pipeline shares yielded an average of 2.2 percentage points more than a ten-year Treasury note (2.4% as of January 9). That would equate to a 4.6% average yield if this were a normal market. But declines in pipeline stocks have inflated yields (which move in the opposite direction of prices) to surprising levels: 9.4% for Enterprise Products Partners, 8.3% for Magellan Midstream Partners and 8.1% for Kinder Morgan Energy Partners, to name just a few of the top operators.
Investors should expect to see steadily growing payouts as well as rising share prices. The total return for energy master limited partnerships, including payouts and share-price increases, averaged 16% annually over the past decade until the stocks came crashing down last summer. The Alerian MLP Select Index, which tracks 50 energy partnerships, fell by half from its crest last summer before staging a small comeback. As of January 9, it was still 33% below its peak.
The credit factor. Why did these partnerships fall so hard? Frozen credit markets are partly to blame. Because the partnerships pay out most of their profits to shareholders, they must buy and build new pipelines and other facilities to grow. That requires heavy borrowing, and right now banks are reluctant to lend.
Pipeline companies are stymied temporarily, says Gary Bradshaw, manager of Hodges Small Cap fund. "But this problem will pass, and they'll be able to keep growing." In fact, the strongest pipeline companies have continued to raise more money. Kinder Morgan and Energy Transfer Partners each sold hundreds of millions of dollars' worth of bonds in late 2008, and others can tap existing lines of credit if they need to.
Many analysts also blame the collapse in MLP prices on hedge funds, which piled into pipeline shares during good times and then dumped them at fire-sale prices last year when the markets tanked. Other deep-pocketed buyers, such as mutual funds, insurance companies and endowments, have not swooped in because the peculiar tax status of MLPs makes them a headache to own.
MLPs are a bit of a pain for individual investors, too. Much of the income they produce is tax-deferred until you sell the shares -- a nice perk. But the downside is that you must file additional federal tax forms, as well as tax returns in the states in which the pipelines operate. MLPs are best for investors who pay someone else to do their tax returns. Also, you shouldn't hold them in an IRA or other type of tax-deferred account because you could get hit with a tax on something known as unrelated business taxable income.