Get Juicy Income From Battered Energy MLPs

Watching oil prices swoon, you’d think the world had just gone solar. Yet there’s a ray of sunshine in the energy patch: Yields have climbed significantly for master limited partnerships, unusual income investments with plenty of long-term growth potential.

Most energy MLPs run oil and gas pipelines, terminals, and storage depots, earning steady income as long as the oil and gas flow. They distribute the bulk of their cash flow to investors. Although MLPs have some exposure to commodity prices, they generally make money whether a barrel of oil costs $40 or $140.

The sector has slumped because of fears of a domestic oil glut, says Libby Toudouze, a partner with Cushing Asset Management, an MLP investment firm in Dallas. That could lead to production cuts and lower pipeline volumes. If prices stay low for an extended period, domestic drilling could slow sharply, curtailing demand for more pipelines—and ultimately lowering growth rates for MLPs.

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These pressures pushed down the Alerian MLP index by 15% between September 18 and December 18. As a result, the index’s yield has climbed to a healthy 6.2%. Compared with the yields of other kinds of income investments, such as property-owning real estate investment trusts (3.6%), utilities (3.5%) and 10-year Treasury bonds (2.2%), MLP yields look compelling, says David Chiaro, a portfolio manager with Eagle Global Advisors, a Houston investment firm that specializes in MLPs.

MLPs confer tax breaks, too. About 80% of distributions typically consist of return of capital and 20% represent ordinary income, says Chiaro. Although investors may owe tax on the ordinary income, the return of capital is tax-deferred until the stock is sold. (The prior distributions are then treated as ordinary income.) Owning the stocks individually means dealing with complicated K-1 forms. You can avoid the tax hassles by investing through exchange-traded funds or mutual funds. But if a fund holds more than 25% of its assets in MLPs, it must be structured as a C-Corporation and pay corporate income taxes on distributions before the income is passed through to investors. That tax drag makes their total returns dramatically lower than what you would earn by owning MLPs individually.

In a weak oil-price environment, Chiaro suggests MLPs with relatively low exposure to crude and an emphasis on refined products—transporting jet fuel from a refinery to an airport, for example. Demand for those products is likely to grow as the economy strengthens. MLPs that move fuel directly from oil fields are more vulnerable to production cuts, which may slash into their cash flow and distributions. “The further you get from the wellhead, the less risk you have of volume and price declines,” says Chiaro.

Two particularly compelling MLPs are Buckeye Partners (symbol BPL, share price, $75.75; yield, 5.9%) and Magellan Midstream Partners (MMP, $83.38, 3.2%). Buckeye and Magellan mainly own pipelines that transport refined products. Each should have ample cash flow to cover its distributions, says Chiaro, and the payouts are likely to grow at above-average rates over the next few years. Another plus for Magellan is that it doesn’t owe any distributions to a corporate parent, enabling it to pass more cash flow to investors. (Prices and yields are as of December 22.)

Industry giant Kinder Morgan (KMI, $41.55, 4.2%) looks promising, says Toudouze. Kinder recently consolidated several MLPs into one corporation and is now the largest energy-infrastructure company in the U.S., with a stock market value of $88.3 billion, according to Bloomberg. Built through a series of mergers and acquisitions, the company is diversified by geography and asset base, with 54% of its 2014 earnings coming from natural gas pipelines and 82% of its cash flow based on fee income.

Investors won’t receive all the tax breaks of an MLP with Kinder because it pays regular dividends. But the company expects to boost its payouts at a 10% annual clip over the next five years, and, says Toudouze, it is likely to buy more pipelines and other energy assets, helping fuel long-term growth.

Other stocks that Chiaro likes are Energy Transfer Equity (ETE, $56.35, 2.9%), Plains GP Holdings (PAGP, $24.53, 3.1%) and Williams Companies (WMB, $45.64, 5.0%). All three own controlling stakes in underlying MLPs, acting as their general partners. Energy Transfer is the most diverse of the group, with stakes in several MLPs and wholesale and retail gasoline businesses. Plains emphasizes crude oil transportation and terminals. Williams, which is set up as a regular corporation, focuses on natural gas pipelines.

The stocks of the general partners don’t yield as much as units in the underlying MLPs, but they may produce higher total returns. Distributions from the GPs should rise faster than those of the MLPs they control because they’re entitled to “incentive distribution rights”—a rising percentage of cash flow from their underlying MLPs. That should boost their stock prices over time, says Chiaro. The GPs may also benefit from industry consolidation, he adds, because the MLPs they control are in a good position to buy more energy assets—and ultimately send more cash to their corporate parents.