The Energy Sector’s Best Low-Risk, High-Yield Opportunities
Contrary to popular belief, you can earn juicy yields well beyond what a bank or Treasury bond offers without taking on too much risk.
All you need to do is make one simple move… and you can even lower your tax burden as well.
It’s achieved by investing in Master Limited Partnerships, or MLPs for short.
Due to an obscure law passed during the Reagan era, companies that service the oil and energy sector are allowed to funnel profits directly to their investors.
And because of a unique tax loophole, investors who hold MLPs for the long term can completely avoid paying taxes on 80-90% of all of their earnings.
For MLP investors, those returns can be substantial. In fact, several of the 50 companies in the benchmark Alerian MLP Index offer yields of 7.5% or higher, and the index’s current yield is 6.45%. That doesn’t include the gains in the underlying shares.
When including these yields and dividends, the Alerian MLP index has outperformed the S&P 500 in 12 of the last 15 years.
And that’s not including the tax-savings you would get from investing in MLPs rather than regular shares…
What is a Master Limited Partnership?
For the most part, MLPs are involved in the business of connecting energy-producing fields with refineries, distribution, and retail sales centers.
In practice, that typically means companies engaged in the extraction, storage, and transportation of energy commodities such as oil, natural gas, and coal, although MLPs do crop up in other industries, such as shipping.
But, despite popular belief, most have limited exposure to commodity prices.
That’s because most MLPs own midstream energy assets such as feeder pipelines and storage and transport facilities.
It’s a great business model because MLPs don’t actually take ownership of the commodities. They transport, store, and process them.
Doing so, they simply act as gate-keepers, extracting a heavy toll every time a transaction takes place. So when oil or gas is moved from Point A to Point B, MLP pipeline owners get paid.
Or when oil moves through the system and has to be stored. In fact, almost anytime anything happens in the energy sector, MLPs investors get paid, whether the price of oil, natural gas, coal or other commodities goes up or down.
It all adds up to healthy profits that, by law, are passed on to investors.
How Master Limited Partnerships Beat the Tax Man
But here’s what’s really great…
Unlike ordinary stocks, MLPs offer a significant tax shield for investors.
You see, like real estate investment trusts, MLPs are pass-through entities that transfer profits and losses to individual unit holders.
But, because of depreciation allowances, 80-90% of the distribution you receive is considered a return of capital by the IRS. So you don’t pay taxes immediately on that portion of the distribution.
In other words, 80-90% of the distribution you receive is tax-deferred. The remaining 10-20% is taxed as regular income.
But here’s the real kicker.
You’re not taxed on the return of capital until you sell the units. What’s more, those payments are used to reduce your cost basis on the MLP.
Let’s suppose you purchase an MLP for $50 and receive $5 in distribution payments, $4.50 of which is considered a return of capital. You pay no income tax on that $4.50.
In this case, only the remaining 50 cents is taxed as regular income. Meanwhile, after one year, your cost basis drops to $45.50 ($50 minus $4.50).
Assuming the distribution remains the same the next year, your cost basis would drop again to $41.00. And so on… and so on.
Eventually, your cost basis could go to zero, leaving you with zero tax liability on 80-90% of your returns.
And if you decide to sell the units sooner, the capital gains are taxed at the more favorable long-term capital gains tax rate – a tremendous benefit, especially for older investors.
MLPs do complicate your tax preparations, so you may find it easier to consult a tax professional. But the additional expense should be well worth it.
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Investing in Master Limited Partnerships
Explosive growth in shale and other unconventional gas production has given MLP investors a wave of new opportunities. That should allow them to continue to expand distributions to investors.
The United States is in the early stages of one of the greatest financial booms in its history. Technological advances in horizontal drilling have allowed companies to access natural gas and oil resources once thought to be unattainable.
Upstream gas drillers continue to develop shale deposits in Pennsylvania, New York, Utah, and other states. So someone has to take care of all the gathering, feeder and transport pipelines, terminals, storage facilities, fractionating, and initial processing of these fuels.
Investing in MLPs Now: Three High-Yield Picks
The tax savings and tax deferrals are part of what makes MLPs such attractive opportunities.
However, that doesn’t mean you can buy an exchange-traded fund (ETF) that holds many MLPs and reap the benefits.
The two most popular exchange-traded funds (ETFs) available – the Alerian MLP ETF (NYSE:AMLP) and JPMorgan Alerian MLP Index ETN (NYSE:AMJ) – pass their profits through as ordinary dividends, so you lose the big tax advantages.
Instead, you’re better off taking a look at one of the following high-yielding MLPs.
For those seeking the most bang for their investing buck, I’ve identified three MLPs with dividend yields that pay more than 5% that have strong track records and solid future prospects. They are:
- Genesis Energy LP (NYSE:GEL) – Current Yield: 5.6%. Genesis is one of the most diversified midstream players, meaning it has multiple income streams. The company has about 1,000 miles of pipelines across five states, mostly in the Gulf of Mexico, a fleet of more than 270 trucks and trailers, 50 barges, more than 80 railcars, and a number of terminals and other tank locations. To top it off, the company recently acquired the M/T American Phoenix from Mid Ocean Tanker Company, a 330,000-barrel Jones Act tanker whose services are already chartered into 2020. Distributions have increased for 39 consecutive quarters, making this an income machine.
- Enbridge Energy Partners LP (NYSE:EEP) – Current Yield 6.8%. While many other energy companies have seen share prices plunge along with the price of oil, Enbridge has held up better. The company is also planning to restructure and shift some of its most lucrative pipeline assets from its Canadian management company, Enbridge Energy Management, to its U.S. MLP. Thanks to its operations in western Canada and the North Dakota Bakken formation, the company is the largest pipeline transporter of oil production from those two regions, accounting for approximately 17 % of total U.S. oil imports. Its natural gas business is equally strong, delivering approximately 2.2 billion cubic feet of natural gas daily in the U.S. mid-continent and Gulf Coast regions. Its high yield dividends have increased every year since 2006, and one-year returns of 40.93% make it a strong candidate for ongoing income and long-term appreciation.
- Crestwood Midstream Partners LP (NYSE:CMLP) – Current Yield: 14.5% Crestwood Midstream Partners operates natural gas pipelines and processing and storage facilities in premier shale plays across the U.S., including the Marcellus Shale, Bakken Shale, Eagle Ford Shale, Permian Basin, Powder River Basin Niobrara Shale, Utica Shale, Barnett Shale, Fayetteville Shale, and Haynesville Shale. Dividend payments have risen steadily since 2011, and its net income of $21.7 million for the first quarter of 2015 is the highest in the company’s history, representing a 34% increase over the first quarter 2014. Its oil compression volumes hit a new high of 692 MMcf/d. The stock has an upside of 29%, according to analysts’ one-year price target, and that coupled with its very high yield makes it a solid, high-income choice.
With 10-year Treasury notes offering yields around 2.4% and CD rates hovering near 1%, MLPs are an investors’ best defense again the Fed’s war on savers.
The right mix of high-yielding MLPs can replace what the Fed has taken away – and help you build a golden retirement.
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