Energy Investing for Income in A Low-Rate Environment

Over the years, one of the main reasons that the energy sector has been popular with investors is its reputation for producing investment income. With interest rates at near record lows, that role is arguably more important today than ever, as finding a reliable yield elsewhere is much more difficult than it has been in the past.

When the financial system ground to a halt and the stock market came crashing down in 2008/9, the Federal reserve and other central banks responded in two ways. They embarked on programs of bond buying known as QE that added massive amounts of liquidity to financial markets and they cut interest rates to historic lows. Both were intended to be temporary, emergency measures, but a decade on, rates are still at or near historic lows and liquidity is once again being pumped into the system. That presents a problem for that often-forgotten class of investor, the income seeker.

These are people who did the right thing for their entire working lives. They funded their 401ks and other investment accounts and stayed the course through some periods of scary volatility. They did so because they were told that if they did, they would reap the rewards in retirement when their investments could be shifted to income producing, safe things, like Treasury bonds. Even at what was then considered a conservative yield estimate of 5 or 6 percent, they would be set for a long, happy retirement.

The 10-Year Treasury note is currently yielding under 2.8%. To put none too fine a point on it, they got screwed.

The answer for many has been to take on added risk. They have shifted to high-yield bonds (also known as junk bonds) maybe, or Real Estate Investment Trusts (REITs). The problem is that as they have done so, the spread between those supposedly high-yielding, risky investments and Treasuries has closed up. 

Sure, you can get around 4.9% from an ETF such as JNK, but do you really want all your savings tied up in something that is called “junk”? REITs may not be quite as risky, but given that real estate prices are back to record highs, I’m not sure that the 3.3% offered by a REIT ETF like RWR is particularly enticing.

For many people caught in that situation, incorporating energy stocks and funds into their portfolio is a good way of juicing yield without risking everything.

There are many ways of getting yield from the energy sector. The most obvious is just to buy stock in the big, integrated oil firms. Those stocks, such as Exxon Mobil (XOM) and Chevron (CVX) have been under pressure recently, but for yield seekers, that makes them more, not less attractive.

Let’s face it, even though the stocks in big oil are falling, I don’t think anyone really thinks that the companies are in any trouble. For XOM, for example, “struggling” means “only” making $88.58 billion over the last year. You may have some capital risk, but I would rather buy something at its lows than at its highs. XOM currently yields over 5% and the company has a history of raising its dividend, which makes it worth the risk.

Less risky in some ways given the current U.S. oil market dynamics, are Master Limited Partnerships (MLPs). These, like REITs, are “pass-through” entities, where the profits are passed to the shareholders, not retained by the company.

That leads to high yields, but it can create a problem for some investors with complicated tax reporting requirements.

The reduced risk comes from the fact that many of them are “mid-stream” oil companies. They own and operate pipelines. The increased production in the U.S. may be keeping prices down which is hurting the sector overall, but it means more business for the pipeline companies.

Given that, while there is still enough risk to make this a play suitable for only part of your portfolio, the 9.1% yield on the Alerian MLP ETF at the time of writing can go a long way to lifting your overall income.

In a low-rate environment, investors who need income from their investments need to think beyond the traditional bond portfolio. That means taking on some risk, which should be evaluated against the potential rewards. After a decade of under performance, the energy sector will recover at some point, giving a chance of capital appreciation, but that is just a bonus. Even without that, the available yields of double or even triple those from Treasuries make it a place that yield-seekers need to be.

 

Cheers,

 

M

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