Pros and Cons of Energy Income Investments

  by Shelley Seagler

The energy sector provides some of the best yields in the stock market. In particular, energy transportation and storage companies operating as partnerships have historically provided higher yields than bonds or dividend stocks. Utilities and other traditional energy-related stocks also provide greater dividend yields than the S&P 500 index.

Let’s take a look at energy investments, why they are attractive to income investors, risk factors to keep in mind and some alternatives to consider.

What Are Energy Investments?

There are many different types of energy. Fossil fuels like crude oil and natural gas power the transportation industry and provide heating to millions of homes, respectively. On the other hand, renewable energies like solar, wind and nuclear power are slowly overtaking coal as the primary source of power for electrical grids throughout the nation.

There are also many different parts to the energy supply chain. Oil and gas producers must extract the commodities from the ground using drilling or fracking techniques and pipeline operators transport the commodity across the country. Solar, wind and nuclear operators focus on building capacity and delivering it to electrical grids at optimal prices.

Each energy investment has its own unique business model and economics. For example, crude oil demand depends on factors like travel whereas natural gas demand is more heavily influenced by weather. Nuclear and wind projects have a high upfront cost and lengthy payback period but could provide lower cost energy and better margins over time.

MLPs Generate High Yields

Most income investors are focused on Master Limited Partnership, or MLPs, which are typically involved with energy transportation, processing and storage. They have fee-based business models (e.g., a set fee for each barrel transported, stored or processed), which provides investors with a predictable, recurring cash flow over time.

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Unlike corporations, MLPs do not pay tax at the entity level and operate as partnerships with two classes of owners. General partners control the operations and typically own a 2% equity interest along with incentive distribution rights (IDRs). Unitholders provide capital without playing a role in operations or management in exchange for distributions.

Energy Income Investments

MLP Performance vs. Other Income Sectors – Source: Alerian

Over the past decade, MLPs have returned an average of 7% per year to shareholders, which compares to 4.1% for REITs, 3.9% for utilities and 2.5% for bonds, according to Alerian. Distributions are not taxed when they are received, but rather, are considered a reduction in the cost basis in the MLP investment—making them best suited for taxable accounts.

Keep in Mind the Risk Factors

There are several key risk factors that energy investors should carefully consider. While some of these risk factors apply to broader income investments, there are many unique considerations that apply to energy MLPs and corporations.

The most important risk factors include:

  • Commodity Price Sensitivity: MLPs do not own the commodities that they transport but they still have some level of commodity price sensitivity. If commodity prices fall, upstream companies could drill less, and demand could fall for pipelines.
  • Interest Rate Risk: Most investors own MLPs for yield, which means that their demand-side economics are influenced by interest rates. Higher yielding alternatives could lead to an outflow from MLPs and lower prices for unitholders.
  • Legislative Risk: Changes to the MLP tax status are unlikely but still represent a key risk factor for unitholders. That said, bipartisan legislation has been introduced to extend the MLP structure to renewable energy projects.
  • Environmental Risk: The transportation of fossil fuels involves a certain level of environmental risk. For example, aging pipelines have led to gas leaks and high-profile oil spills have polluted waters around the world.
  • Renewable Energy: Solar, wind, hydro and nuclear power are continuing to encroach on traditional fossil fuels. While renewable incentives vary over time, the economics of renewables have improved over time as costs continue to fall.
  • Permitting Risk: The permitting process for new pipelines can be a complex process that involves both regulatory approvals and permits, as well as environmental impact studies and eminent domain considerations.
  • Tax Preparation: While not exactly a risk, MLPs generally issue a K-1 for tax reporting. This will make tax preparation more complex and could delay filing. In many cases, investors don’t receive their K-1 documents as fast as other tax forms.

These risk factors are often detailed in each company’s quarterly and annual reports. In addition, shareholders and partners should consider participating in quarterly earnings conference calls where analysts often weigh in on risks.

Income Alternatives to Consider

There are many different ways for investors to generate yield—even in today’s low interest rate environment. While bonds are the most popular way to generate an income, real estate investment trusts (REITs), utilities and dividend stocks are popular alternatives to generate a reliable income for retirement or other purposes.

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Energy Income Investments

Ethereum’s DeFi Ecosystem – Source: TheBlock

There are also a handful of lesser-known strategies:

  • Private REITs: A growing number of companies offer real estate investments online. While these REITs aren’t as liquid as public REITs, they could benefit from lower costs and greater flexibility given the lesser regulatory burden.
  • Peer-to-Peer Lending: New platforms make it possible to make personal loans to individuals online. While these loans may offer high interest rates, investors must consider creditworthiness and other risk factors.
  • Crypto DeFi: Decentralized finance, or DeFi, enables crypto holders to generate yield from their assets by lending them to margin traders and other individuals on a short-term basis, generating potentially attractive yields.
  • Selling Options: Covered call options and other strategies enable investors to generate yield from their existing stock positions in exchange for limiting their upside. These strategies can be a great way to generate incremental yield from a portfolio.

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The Bottom Line

Energy investments are a popular way to generate income. In particular, energy MLPs offer attractive yields that often go above and beyond REITs, utilities and bonds. Investors should carefully consider the risks associated with these investments before adding them to their portfolio, including the tax implications of partnerships.

If you’re looking for ways to boost income, the Snider Investment Method can help you maximize income with stock options. Get started today!

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