This Energy ETF Will Soon Step on the Gas
Last week, I discussed some of my favorite income plays for 2021. Income stocks were largely overlooked last year as a result of the coronavirus pandemic.
I believe that is about to change. Most growth stocks are trading at very high earnings multiples. I don’t think those high multiples are warranted.
My guess is the stock market will flatten out during the first half of this year. Unemployment remains stubbornly high and many businesses have accumulated a lot of debt to stay afloat.
If I’m right about that, Wall Street may soon be looking for companies trading at low multiples with strong cash flow. They need to look no further than the energy sector to find some outstanding values.
Over the past two months, the price of oil jumped by more than a third. Since closing below $36 per barrel on October 30, the price of crude oil closed above $48 on December 23.
Of course, much of that gain can be categorized as a “reopening trade” due to the rollout of several vaccines for COVID-19. Over the same span, the S&P 500 Index gained 23%.
That result is perfectly rational. If the vaccines allow the economy to fully reopen soon, demand for oil should rebound strongly in 2021.
What isn’t rational is the 32% drop at the same time in the Alerian MLP ETF (AMLP). If drillers will be producing more crude oil, the black stuff will need to be transported from the wellheads to the refineries.
The Alerian MLP ETF owns shares of the biggest “midstream” energy master limited partnerships (MLPs) that transport and store crude oil and natural gas. Its top three holdings are MPLX LP (NYSE: MPLX), Enterprise Product Partners (NYSE: EPD), and Magellan Midstream Partners (NYSE: MMP).
Take or Pay
That divergence in performance begs the question: If the price of crude oil is going up, why is the price of MLPs going down? Presumably, oil drillers will increase production to take advantage of higher prices.
One possible explanation is that increased production will prevent oil prices from going much higher. If so, that’s more of a problem for the oil drillers.
Most midstream MLPs generate the majority of their revenue under fixed “take or pay” contracts. That means they get paid the same amount of money regardless of the price of oil or how much of it is actually transported.
However, Wall Street doesn’t seem to think that the big oil producers will take a hit. Over the past two months, the iShares U.S. Energy ETF (IYE) is up more than 30%. Its top two holdings, Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX), account for nearly half of its performance.
Something is amiss. I smell an opportunity for income investors to lock in a high yield and capital appreciation in 2021.
AMLP’s most recent quarterly cash distribution of 71 cents equates to a forward annual yield of roughly 11%. That is a bit less than the distributions made in May and August. At that time, nobody knew when a vaccine for the virus might be forthcoming.
But now we know that it is only a matter of time until those vaccines have been administered to enough people to safely reopen the economy. That’s why the price of oil is on the rise and the stock market has been going gangbusters.
No Matter the Weather
At some point, AMLP’s share price should rally to come back into line with the rest of the energy sector. When that happens, its yield will drop as its share price heads higher.
It is not unreasonable to expect a total return (capital appreciation plus dividends paid) in excess of 20% from AMLP this year. To do that, its share price would only have to appreciate 10% from where it is today.
For context, AMLP is currently trading more than 40% below where it was a year ago. And that was after it had already dropped in half from its peak price in 2014.
To be sure, MLP prices won’t zoom back up to their pre-coronavirus pandemic levels anytime soon. Most of them have renegotiated contracts with their customers in exchange for more predictable cash flow. Even still, they should be able to continue paying distributions at their current levels as long as the economy doesn’t shut down again.
If that idea does not excite you, consider buying a long-term call option on AMLP instead. Last week, the call option expiring next January at the $25 strike price could be bought for $3.
If AMLP makes it back to $30 by that time, the return on this trade would 67% ($2 profit divided into the $3 option premium). AMLP briefly rallied above $30 in June as the daily case count for COVID-19 waned during the warm summer months.
In this case, we don’t have to rely on the weather to make this trade work. The vaccines will take care of that.
Our colleague Jim Pearce just pinpointed an appealing total return play in the energy sector for 2021. Crude oil is the world’s most valuable commodity. Another crucial commodity is gold.
Gold prices soared in 2020 and our investment team predicts that the “Midas metal” has further to run in 2021. Our preferred way to profit from increases in gold prices is through small-capitalization miners that can put operating leverage to work.
The Investing Daily team has unearthed a gold mining stock that’s positioned for market-crushing gains. If you act now, this gold play could hand you several times your money. Click here for details.