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Tempting Yields in the Energy Patch: No Free Lunch

By John Persinos on June 13, 2017

During our recent getaway to Palm Springs, California for sunshine and golf, my wife Carole noticed a card slipped under our hotel door that promised a free lunch for two if we stayed another night.

She asked me if we should extend our stay. Ever the curmudgeon, I grumbled: “Look what they’d get in return. There’s no such thing as a free lunch.”

“There’s no free lunch,” of course, expresses the idea that there’s always a trade-off or cost for something, even if it’s hidden. Which brings me to high-yielding energy master limited partnerships (MLPs).

Crude prices are generally on the upswing after a long, bleak journey in the wilderness that saw oil prices drop from highs near $110 in the mid-summer of 2014 to as low as the mid-$20s in February 2016. With crude now hovering at $50 per barrel, yield-hungry investors are gravitating to MLPs again.

But don’t be enticed by high yields alone. Whether it’s a Palm Springs hotel or an MLP’s yield, nothing is just handed to you. As I explain below, the key is whether the yield is sustainable, which in turn is determined by the strength of the cash flow behind it. I also pinpoint one of the best MLPs you can find right now.

Energy at break-even?

Ari Charney, chief investment strategist of Utility Forecaster and income expert at Personal Finance, explains the renewed appeal of MLPs:

“Although the energy sector is not out of the woods yet, odds are last year marked the bottom of this cycle. Energy commodities are up sharply from their lows, but the continuing glut of production has put a ceiling on energy prices.

That, in turn, means that even if you didn’t buy at the bottom, many MLP names still trade at attractive valuations.”

But more than ever, you must be extremely selective. The most reliable yields are those supported by strong distributable cash flow (DCF) — i.e., operating cash flow minus capital expenditures. DCF (the MLP version of free cash flow) reflects the cash that a company can generate after spending the money necessary to maintain or expand its asset base.

Without sufficient DCF, payouts must compete with capital expenditures for corporate funding. If the company encounters trouble with its financing, payouts run the risk of getting cut. During the long energy price recession from the summer of 2014 to mid-2016, this merciless dynamic played out among high-yielding MLPs. But since the second half of 2016, the energy price recovery has breathed new life into the once beleaguered MLP sector.

To be sure, energy prices have slumped recently on reports of strong production and climbing inventories. Both West Texas Intermediate and Brent North Sea Crude last week dropped below the important $50 per barrel threshold, to about $47/bbl and $49/bbl, respectively.

It doesn’t help prices that the Energy Information Administration’s latest Short-Term Energy Outlook estimates that U.S. oil production will hit a new record high in 2018. Luckily for energy investors, OPEC met on May 25 and announced an extension to voluntary production cuts through March 2018 that were originally set to end in June 2017.

As Robert Rapier, chief investment strategist of The Energy Strategist, puts it:

‘The oil markets have been searching for a bottom since OPEC’s meeting last month in which they decided to maintain production cuts. I shudder to think of where oil prices might have ended up had they abandoned the cuts, as crude prices have dropped about 10% with the cartel keeping the cuts in place.”

Regardless, Robert is optimistic that the price of crude has found a floor at about $50/bbl, the threshold at which energy companies (broadly speaking) break even.

The yield trap…

Igor Greenwald is chief investment strategist of Income Millionaire (formerly published under the name MLP Profits). An expert on high-yielding investments, Igor warns against yield traps. He cites recent woes among MLPs:

“Low energy prices chipped away at their cash flow, of course, but not enough to imperil the distributions. Those were done in by the fact that those MLPs still had huge, expensive projects in the works.

Their operating cash flow could support distributions or capital spending, but not both. When market declines raised the yields they also jacked up the cost of equity capital, making equity sales an impractical financing source.

When lenders and the credit rating agencies pulled back as well, some partnerships and companies had no choice but to cut the dividend in order to pay for growth.”

Another concern is rising interest rates. As with real estate investment trusts (REITs), MLPs are pass-through business models, meaning that they pay no corporate taxes because they payout the majority of their cash flow as distributions.

That means MLPs must continually tap external debt and equity markets to complete new projects to grow payouts. Higher interest rates translate into higher debt costs. What’s more, as interest rates rise, yields on risk-free investments such as Treasury bonds rise in tandem, creating more competition for new capital.

Higher interest rates also drive up the value of the U.S. dollar, a trend that’s a headwind for the energy sector. Oil is traded around the world in U.S. petrodollars. When the value of the greenback goes up, the value of oil tends to go down, and vice versa.

And yet, none of these caveats should dissuade you from MLPs, as long as you stick to quality.

A stream of income…

One solid MLP that passes muster and warranted inclusion in the Income Millionaire portfolio is Enterprise Products Partners (NYSE: EPD).

With a market cap of $57.9 billion and based in Houston, Enterprise Products Partners provides midstream energy services to producers and consumers of natural gas, natural gas liquids (NGLs), crude oil, petrochemicals, and refined products. The company’s assets include 51,000 miles of pipelines, seven offshore Gulf of Mexico hub platforms, and NGL import/export terminals on the Houston Ship Channel.

EPD has a long history of steady growth, regardless of the ups and downs of the energy patch or interest rate gyrations. EPD’s reliable track record of payouts has enabled it to reward investors robust and rising income over the years, with healthy total returns to boot.

One of the keys to Enterprise Products Partners’ success is prudent, conservative management that has kept a lid on debt levels, with a steady-as-you-go approach to payout growth.

At BBB+/Baa1, Enterprise Products Partners now boasts one of the highest credit ratings among MLPs, underscored by a debt-to-adjusted EBITDA (earnings before interest, tax, depreciation and amortization) ratio that has averaged a reasonable 4.3 times over the past 12 months. The MLP has maintained high distribution coverage ratios, which has enabled it to retain greater cash flow to plow back into future growth.

With a current yield of 6.15%, Enterprise Products Partners is an income-generating machine, even in times of rising interest rates and volatile energy prices. We’ll keep unearthing these safe, high-yield gems for you.

Questions or comments? Send me a letter: mailbag@investingdaily.com — John Persinos

An energy investment with “true grit”…

MLPs aren’t the only way to invest in the resurgent energy sector. Fracking operators are reliant on “frac sand,” a proppant designed to keep an induced hydraulic fracture open, during or following a fracturing treatment. Those who invest early in the right sand producers stand to reap a windfall.

An advanced, high-purity sand compound known as “Augmented SiO2” is being used to unlock the second largest oil field on the planet. This material is so critical to the fracking process that some oil producers are paying up to five times the normal price for it, and demand is booming.

Augmented SiO2 has the potential to exponentially boost American energy production, stealing influence from Saudi Arabia and other major foreign players. This compound already is creating the next wave of energy millionaires.

Our in-house energy expert Robert Rapier will walk you through this opportunity, and send you his report on the three best Permian plays. Click here now for his presentation.

 

 


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