Income and Growth: All Wrapped Up Together in These Energy Plays
by David Fessler, Investment U Senior Analyst
Thursday, September 22, 2011
In these tumultuous markets, investors are shunning growth stocks in favor of income-producing investments.
But low-yielding bonds aren't the place to be unless you're a go-hide-in-a-corner-and-wait-till-the-storm-passes kind of investor. Faltering commercial real estate investment trusts (REITs) carry too much risk. And you can forget bank yields, as they're practically zero.
The two hottest - and seemingly safest - places to be these days are in U.S. royalty trusts and master limited partnerships (MLPs). But not just anywhere. The best ones - you guessed it - are in the energy sector.
What's the Differences Between Royalty Trusts and MLPs?
Both are yield-oriented, and typically generate huge quarterly cash distributions for their shareholders.
Both types of investments focus on oil and natural gas production to generate cash flow.
The difference between a master limited partnership and a royalty trust is usually whether the management team is oriented towards acquisitions or not.
- MLPs are great acquisition structures, especially for mature upstream oil and gas producing companies.
- Royalty trusts make sense for companies that aren't acquisition oriented, but may still have great income-producing oil and gas properties. Since a royalty trust has a finite life, it fits better with these types of operations.
When you invest in a royalty trust, the distributions you receive are actually part income and part of your original principal. At the termination of the trust, typically 20 years, you will have received nearly all of your original principal back.
With a general underlying bullish uptrend in commodities, royalty trusts and MLPs should be considerations for risk-averse, income-oriented investors.
Tax implications are different between royalty trusts and MLPs, as well. Most royalty trusts are IRA-friendly, as they typically generate small amounts of taxable income.
Most MLPs file a K-1, similar to other limited partnerships. Investors should consult a knowledgeable tax attorney to determine which structure is right for their particular situations.
Great Time to Be in Either
Regardless of which type of investment you decide is right for you, it's a great time to be in either, particularly in the energy sector.
With the U.S. printing presses running full blast, it's only a matter of time before inflation rears its ugly head. Commodities like oil and gas do very well in inflationary environments, or even the anticipation of them.
MLPs have the ability to hedge their production any time, while royalty trusts can only do it at the beginning of the trust. As a result, royalty trusts have increasing exposure to commodity prices as the trust ages.
Two MLPs and One Royalty Trust Equals Three Great Examples
Yes, today has been a rough day in the markets... and there's been a bit of a sell-off in the energy sector, particularly in the refineries. But it's creating a terrific buying opportunity for high-yield MLPs and royalty trusts. If you're looking to build your portfolio and yield exposure over the long term, now is the time to pay attention to these high-quality income producers.
Two great examples of MLPs delivering solid returns for their unit holders are:
- EV Energy Partners, L.P. (Nasdaq: EVEP) - EV Energy Partners has tremendous upside potential based on its yet undeveloped landholdings in the Utica Shale. As more and more of the Utica acreage is de-risked, EV Energy Partners' share price should respond in kind.
- Linn Energy, LLC (Nasdaq: LINE) - Linn Energy is developing its holdings in the Granite Wash play to the tune of 30-percent production growth per year. This level of growth is relatively unknown in the energy MLP space. It could turn out to be the leader in distribution growth for this year and next. In addition, shares could see a 50-percent appreciation in the next 12 months.
Both also hold the prospect of future capital appreciation, as well.
A great royalty trust can be found in VOC Energy Trust (NYSE: VOC), which sports a yield to maturity of over 10 percent. Investors in the trust should do very well over its lifetime.
Whether it's royalty trusts or MLPs that fit your investment strategy the best, both warrant a closer look if you're interested in increasing income and capital appreciation in the energy sector.