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Income Plays for the Energy Rally

By Igor Greenwald on September 27, 2017

Hope springs eternal in the oil patch but this time it might not be misplaced, as strong global demand begins to visibly drain the crude glut.

Some energy stocks are already responding, while others remain steeply marked down. Many continue to generate attractive dividend yields fully covered by cash flow that will swell as energy prices recover.

U.S. oil prices have lagged the global gains, held back by the disruptions from Hurricane Harvey and expectations of big production growth next year. But global inventories are now plainly getting drawn down, and as a result the global benchmark Brent is nearing $60 a barrel.

The wider spread between Brent and U.S. prices has been great for U.S. refiners, especially those with easy access to overseas exports markets. The stock of industry leader Valero (NYSE: VLO) has hit record highs in recent days but continues to yield 3.7%. Valero spent $1.3 billion on dividends and share buybacks in the first half of 2017, equivalent to an annualized return yield of around 8%. Those outlays consumed 80% of the refiner’s free cash flow.

Refining margins have improved in the third quarter but have historically been volatile. Higher U.S. crude prices could cut into Valero’s windfall, for example.

The midstream pipeline sector involved in gathering, shipping and processing crude oil and natural gas as well as fuel has more to gain from higher oil prices, and less to lose from foreign competition. The pipeline operators remain steeply marked down and would benefit from higher U.S. energy output as well as increased consumption.

The Texas pipeline giant Enterprise Products Partners (NYSE: EPD) yields an annualized 6.4%. The distribution is as safe as any in energy, backed by a large and diverse base of midstream assets. Rival Energy Transfer Equity (NYSE: ETE) is riskier but has more upside given its claims on the cash flows of affiliates. Its yield is at 6.6% annualized.

Their returns have been outpaced of late by those of lower-yielding energy securities with faster growth rates. Dominion Energy Midstream Partners (NYSE: DM) yields a relatively modest 3.4%, but expects to increase distributions more than 20% annually for the next several years. The Virginia utility’s affiliate owns gas infrastructure assets including the East Coast’s only liquefied natural gas export terminal, which is due to come online by the year’s end under long-term supply contracts. Its share price is up 27% since mid-August.

EQT GP Holdings (NYSE: EQGP) yields 3% and also plans to boost its payouts more than 20% annually. It represents the general partnership interests of gas driller EQT (NYSE: EQT) in its midstream affiliate, and is up 11% over the last six weeks on speculation that those midstream interests will be sold eventually.

Investors interested in high current yield might consider Enbridge Energy Partners (NYSE: EEP), yielding a well covered 9% after jettisoning its gas assets and cutting the distribution earlier this year. The Series A preferred shares of Targa Resource Partners (NYSE: NGLS-A) yield 8.3% and those distributions have precedence over Targa’s common dividends.


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