The Illusion Of High Yields

Several times in the last few months I have suggested that investors look to accumulate energy stocks for the long term right now, based on the belief that the mid-$40s lows for WTI would hold. There are two provisos that must go with that suggestion. First, you must be prepared to cut any position, probably for a loss, should oil break below $40. Second, not every energy company is a bargain at current levels. The second proviso is particularly important for those seeking income from their investments.

In an environment where a 10 Year U.S. Treasury yields around 2 percent, and that is positively extravagant compared to Bund yields, it is understandable that published yields in the teens for oil and gas Exploration and Production (E&P) are attractive to income seekers. Of course, as some of you may realize, the yields published on Yahoo Finance or wherever you may look bear little or no relation to the current reality. They are based on distributions from the last twelve months, during six of which WTI crude was fetching over $100/Barrel, but the current price, however, reflects expected distributions in the next twelve months.

Thus, when you see a yield of 16.23 percent for Breitburn Energy Partners (BBEP), for example, or 17.31 percent for Atlas Resources LP (ARP), it is not realistic to expect that in the near future. The price of both of those stocks has more than halved in the last six months as the market anticipates significantly lower distributions.

That doesn’t mean that neither stock is of interest, however. Both have near record high short interest and are trading just above their lows, meaning that from a trading perspective they set up nicely for a short term trade. The key words here are “short term”; both BBEP and ARP are worthy of consideration as a trading opportunity, but the uncertainty about future distributions make them unsuitable for income seekers.

If that is your need from an energy investment, then large, integrated oil companies are a much better bet. Those companies derive revenue from exploration and production, but also from downstream operations, or refining. While the value of the oil that they take out of the ground is depressed, the volatility in oil prices actually increases margins on that side of the business. That balance will enable them to ride out the storm, without any significant reduction in dividend payouts.

Of the large global companies, BP (BP), with a 6 percent yield, is by far the highest payer. There are, of course, reasons for that. BP is heavily invested in Russia and there is still uncertainty as to the total cost of compensation for the Deepwater Horizon disaster. Those risks put the dividend somewhat in doubt, but the company take pride in decades of raising their dividend, so will do whatever it takes to avoid a cut. Exxon Mobil (XOM), with a 3.7 percent yield, and Chevron (CVX) which yields just above 4 percent look like safer alternatives, but the 50 percent premium to that which BP offers suggests that the risks are more than priced in.

Whether you choose the safer, but lower paying XOM and CVX or embrace a little risk with BP, one thing is for sure: The energy sector has traditionally been a good source of income for investors, and still is, but don’t be tempted by the seemingly sky high yields of under pressure E&P MLPs. Those yields are an illusion and when cuts in distribution come, which they almost certainly will, you could be left with similar yields to an investment in BP, with a lot more inherent risk.