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Is This The Oil Play Of 2020?

Alex Kimani

As we kick off the 2020s, it’s perhaps time to stop looking at the drillers and focus on the companies that hold the mineral rights as investors get whiplash from the oil and gas rollercoaster. 

The highest yields in oil are not where you’ve probably been looking for them. 

There’s a high-yield play brewing in the oil patch as a group of companies continue amassing mineral rights beneath oil fields. 

Royalty oil and gas MLPs such as Energy Transfer Partners (NYSE: ET), Kimbell Royalty Partners (NYSE:KRP) and Viper Energy Partners (NASDAQ:VNOM) are devouring mineral assets and paying out generous cash distributions in the 10-30% range--a breath of fresh air in an industry starved of decent returns.

Is it possible this is still a good time to double down on the $550-billion industry?

Maybe, for the extra-savvy investor, and here’s why:

MLPS, or Master Limited Partnerships, are business ventures that operate as publicly traded companies with the company that manages day-to-day operations being the general partner while the investor acts as a limited partner. 

An MLP is required by law to derive at least 90% of its cash flow from commodities, natural resources or real estate. They, in turn, distribute cash to shareholders instead of paying dividends like a standard company would. MLPs combine the liquidity of publicly traded companies and the tax benefits of private partnerships because profits are taxed only when investors receive distributions.

Energy MLPs are not obligated to invest in the E&P companies that own them and continue collecting royalties even if producers run bankrupt. This, in effect, means they are less exposed to oil and gas prices than mainstream E&P players. 

Mineral rights also entitle MLPs to the first cash cuts once new oil and gas wells commence production. 

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Another of their most touted benefits is that unlike corporate dividends which are treated as taxable income in the same year they are received, taxes on MLP distributions are deferred. Your distributions though become taxable as capital gains in the same year once your cost basis drops to zero. 

Further, MLPs pass on the majority of their earnings to unitholders thanks to their unique hybrid legal structure (they have no employees with general partners providing all necessary operational services) and also transfer deductions such as depreciation and depletion which lower your cost-basis and your taxable income as well. Their fat distributions can also offer ample downside protection in choppy energy markets.

Take the case of Energy Transfer Partners, for example. This is an MLP that generates its revenue through intrastate natural gas transportation and storage. The company charges fees based on the volume of natural gas delivered through its pipelines as well fees on the amount of stored fuel that its customers choose to reserve. In this case, Energy Transfer Partners does not own the commodity thus reducing its exposure to price fluctuations and volatile energy markets. 

Although ET shares are down 4% in the year-to-date, the 9.6% distribution rate means the shares are still in the green. Meanwhile, KRP stock is up 14% including dividends while VNOM has gained 3.5%. 

In general, companies that aggregate mineral rights have outperformed those that drill wells, as deftly pointed out in this key chart from the Wall Street Journal

Further, analysts think that will continue to do well with two of the five most widely covered minerals stocks having a Buy rating on Wall Street while the rest have a Hold rating.

What About the Risk?

Aggregators sound great for yield, indeed, but they are not without risk. 

First off, many of these companies are small caps. The top 5 most widely covered companies in this sector are worth a combined value of just $6 billion. This can mean poor liquidity. Only 2% of royalty MLPs are publicly traded. 

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Second, their dividends can take a hit whenever producers are forced to idle rigs due to low oil and gas prices, meaning they are still beholden to energy prices to a degree. 

And, finally, be warned that some of the companies in the sector with the juiciest dividends only got there after their shares took a pounding so your timing must be spot on. 

This is why the market has been unkind to MLPs for the past five years. Prior to that, the MLP enjoyed quite a lot of favor. 

But this is where timing comes into play: Because they’ve been out of favor since 2014, their stock prices have plummeted, and their yields have increased. 

That doesn’t mean they’re necessarily in favor now, either. The market still doesn’t like them. But that is precisely why they can be used for long-term gains through a build-up of assets in those MLPs that are the strongest. 

Tapping into this bargain basement is tricky, and you need to do your homework carefully, but if you do it right, you could be looking at 10% yields while the drillers are underperforming the market. 

By Alex Kimani for Oilprice.com

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