Energy Investing for Yield

Energy in its many forms is traditionally fertile ground for investors that want or need regular income from their investments. Utilities have, even in the last few years of ultra low interest rates and puny returns on bonds, often offered yields around 5% and many oil exploration and production Master Limited Partnerships (MLPs) have paid even more in pass through profits to investors. To those of us who remember the 80s, this is hardly stellar, but compared to a 2.5-3% yield on the US 10 year is quite acceptable.

This has provided a much needed source of income for many people, but over the last 3 or four years, that has been only half of the story.

 
If you had invested in, say, the utility NextEra Energy (NEE) or the MLP Markwest Energy (MWE) three years ago, then you would have seen some pretty nice capital appreciation while you were drawing your dividend. This is all well and good, but it is history, and viewing markets with the benefit of 20/20 hindsight is a frustrating exercise.

My role here is not just to look back, but rather to look forward and give an opinion as to what will look that good three years from now. Unfortunately, given what we know and expect from here, it is unlikely that such performance will be repeated by any utility or MLP during that time. Last week, I gave a brief interpretation of the news from the Fed. New Chair Janet Yellen had said in a press conference that the Central Bank expected QE to end by the Fall of 2014 and interest rate rises to follow not long after. When pressed, she indicated that "not long" would be something around 6 months. If this is the case, then both oil and gas MLPs and utilities will both be hit in two ways by the prospect of a rising rate environment before the year is out.

Both would naturally drop on the prospect of higher rates as instruments that derive some of their value from yield. MWE, despite all of that price appreciation, still has a 5.3% yield and while NEE's 3.07% dividend at current prices is not as great, it is still decent for a growing company when the US 10 year is yielding 2.69%. After the end of QE, however, and with Central Bank interest rate rises imminent, many are forecasting a yield of around 4-4.5% on the 10 year note. If that is the case then both MWE and NEE will have to drop significantly in price to maintain their spread over Treasuries. (For the record, while I think Treasury yields will definitely go higher this year, I think 4-4.5% is on the high side. 3.5-3.75% is closer to my view, but the effect on yield instruments will still be the same, if just not as great.)

In both cases, as I said, there will also be somewhat of a "double whammy." Higher US interest rates will lead to a stronger Dollar which will, given that both oil and gas are priced in US Dollars, cause a drop in their price, or at least restrict any rise. For an MLP like Markwest, their value is derived from the oil and gas they own and control.  If that falls in value, so does the company. For utilities, the leveraged nature of their business means that they will be paying more to service their debt, putting pressure on their bottom line, so higher rates will hit the share price in two ways directly. I should point out that NEE and MWE are merely examples here. Given their past performance it is quite possible that they will fare better than others, but the same conditions and pressures will apply to all utilities and oil and gas exploration and production MLPs.

The fact is, though that there will still be opportunity…there always is. If you can do without the income, then I would suggest trimming your overall exposure to utilities and oil and gas MLPs over the next couple of months, with a view to buying back cheaper at or around the end of the year. If you need that regular check, then maybe some diversification within energy MLPs would be a good idea.

One that I like, but that involves a little risk is Cypress Energy Partners(CELP). The risk here is partly that CELP has only been public for less than three months, so has no history of payments to shareholders. This also makes it impossible to tell you what the yield will be, but the forecast is for around 6%. CELP will be vulnerable to higher rates as a yield payer, but their principal business is the maintenance and repair of pipelines rather that exploration and production, so they will be less sensitive to any possible drop in oil and or gas prices.

For those that need regular payments from their investments to supplement income there are very few places to hide when interest rates start to rise. If you are in that boat and can take a pause, do. Even if rates don't rise they are highly unlikely to fall from here. If you can't, then at least consider something such as CELP that shouldn't get hit in two ways.

Other events could, of course, come along and disrupt the scenario laid out here, but all things considered, it looks like it will be a tough couple of years for energy yield plays. I guess I'll just have to work a little harder at finding other money making ideas for you in order to make up for it!