As the price of crude flirts with record highs, you might be tempted to invest in stocks of oil producers and oil-services companies. Fair enough.
But those stocks usually give investors wild rides because they are tied to the unpredictable swings in oil prices.
Patient investors who want a smoother trip should consider master limited partnerships that own pipelines, refineries and storage facilities. "Master limited partnerships are the tortoise versus the hare in the energy world," says Morgan Keegan analyst John Edwards. "They are steady with less volatility than other energy investments."
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MLPs are odd birds. So you should know a couple things about them before you invest. First, MLPs are not taxed at the corporate level and essentially pass all the income they produce to investors.
Second, unlike dividends, which generally remain constant until they are raised (or, occasionally, cut or even eliminated), MLP payouts are tied closely to partnership profits, which can fluctuate dramatically from year to year.
Third, MLPs issue complex tax forms, which can cause headaches when you file your returns. MLPs may even have tax consequences if owned in a retirement account, so it's best not to put them in an IRA.
Energy MLPs have held up well in choppy markets. The Alerian MLP Index, which tracks 50 of the largest of energy MLPs, returned 7% in 2007, compared with 5.5% for Standard & Poor's 500-stock index. The Alerian index gained 44% during the 2000-2002 bear market, while the S&P 500 lost 47%.
MLPs also sport above-average yields, making them attractive to income investors. The average energy MLP currently yields 6.3%.
Edwards thinks pipeline MLPs will perform well in the coming year because high oil prices have forced energy users to rely more on natural gas. That shift means that gas producers need more pipelines, processing plants and storage facilities to handle the new demand and move the products to market, he says.
Even if crude-oil prices pull back from their current highs, that shouldn't have much of an effect on pipeline MLPs, Edwards says, because demand for natural gas is stable enough to support additional infrastructure investment. He finds the prospects for oil infrastructure less compelling. "There's not as much change afoot where oil is coming from, so you don't have as much growth in the infrastructure there," Edwards says.
With new projects coming online, distributions for pipeline MLPs should grow 8% to 10% this year, he estimates. Here are three MLPs that Edwards rates as "outperform":
Dan Duncan started Enterprise Products Partners with two fuel trucks in 1968. With a market value of $14 billion, Enterprise (symbol EPD) is now the largest pipeline MLP.
"Enterprise Products has one of the most experienced management teams in the business," Edwards says. The company has a presence in the Rockies, the Barnett Shale region in Texas, and along the Gulf Coast. It has been able to pay out higher distributions as natural gas production in these areas has flourished.
The firm plans to spend $4 billion this year on new projects, such as the Independence platform and pipeline off the coast of Louisiana. The project will gather and transport up to 1 billion cubic feet per day of natural gas from deep water in the Gulf of Mexico. The company's footprint along the Gulf Coast will benefit from liquefied-natural-gas imports and new offshore production, Edwards says.
Enterprise Products units (the equivalent of shares in the world of MLPs) closed at $32.38 on January 4, off 0.3% in a sharply down market. Based on the previous year's distributions, the units yield 6.1%.
Kinder Morgan Energy Partners (KMP) is betting on the Rockies. It's building the largest natural-gas-pipeline project in the U.S. in the past 25 years, Edwards says.
The 1,678-mile Rockies Express pipeline will allow producers in the Rocky Mountain region to deliver natural gas to the Midwest and east coast states. Part of the pipeline is already in service, with the rest expected to be fully operational by June 2009. The units closed at $55.21 on January 4, up 0.6%. Kinder Morgan has announced that it plans to payout $4.02 per unit this year. On that basis, the units yield 7.3%.
The prospects for MarkWest Energy Partners are pegged to the Barnett Shale region, a hotbed for natural-gas exploration. MarkWest (MWE) plans to expand its East Texas operations with a $28 million investment and spend $21 million more to bolster its natural-gas processing capacity at its Carthage, Texas, plant by 40%.
"I expect substantial increases in natural-gas volumes from MarkWest's East Texas segment," Edwards says. "That's why it is one of our favorite names in the space." The units, which yield 6.4% on the basis of the past year's payouts, closed at $34.56, up 1% for the day.
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