The $28 billion merger between Spectra Energy (NYSE: SE) and Enbridge (NYSE: ENB) may mark a turning point for master limited partnerships (MLPs). Over the past two years, asset prices in the sector have crumbled as oil prices plunged, but stabilization in energy prices and recent consolidation are breathing new life into the group.
Most partnerships are at least marginally protected from falling energy prices through sales agreements based on the volume of products transported or stored. However, that doesn't mean they're entirely immune.
MLPs pay out almost all of their cash flow as distributions and must continuously issue partnership units (stock) or debt to grow. Weakness in energy prices led to lower cash flows and increasing debt loads, scaring lenders for debt issues while investor sentiment fell faster than share prices.
Now energy prices are stabilizing and companies are positioning for the future. I've found a way to play this trend that can reduce the risk associated with individual names while providing a cash yield twice as large as other dividend plays.
Buyers Coming Out As Energy Turns A Corner
The deal between Spectra and Enbridge is the fourth major merger in the past year or so. The dramatic drop in capital expenditures by the largest exploration and production companies is putting a premium on existing infrastructure assets, especially pipelines.
Larger companies are better able to raise cash when they need it and can better control rates through market share. Partnerships are also looking to the future when the oil market finds its balance and prices head higher.
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According to the Oil & Gas Journal, spending on oil and natural gas pipeline transportation plunged more than 70% last year to $9.2 billion. While 2016 spending is expected to more than double, it's still estimated to be 36% lower than 2014 capex.
Investors seem to view recent consolidation as a sign of stabilization and strength, as they sent shares of Spectra and Enbridge soaring on news of the deal.
While the MLP sector could enjoy a near-term bounce on future mergers and rising oil prices, the real upside remains over the next few years. Because companies have been conserving cash flow, infrastructure has likely been neglected. This could lead to bottlenecks in pipeline capacity, allowing partnerships to increase rates on volume of energy products transported, regardless of whether energy prices jump or not.
MLPs Should Be Safe From Rising Rates
Beyond the potential upside from a turnaround in the energy sector, MLPs may be one of the few income investments that are safe from rising rates.
In a study of six rising-rate environments since 1992, MLPs were positive in five of those periods and posted an average annual return of 17.7%. For comparison, REITs posted negative returns in half of the rising-rate periods, and utilities posted negative returns in four of the six periods.
The JP Morgan Alerian MLP ETN (NYSE: AMJ) looks like the best way to play MLPs right now. It tracks the Alerian MLP Index, which invests in 44 master limited partnerships with a concentration in pipeline transportation of natural gas (37% of assets) and petroleum (36%). AMJ pays quarterly distributions (the MLP equivalent of dividends) based on the income received from partnership holdings.
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While the potential profit with AMJ may not be as high as with individual stocks, you get diversification across the entire MLP complex, allowing you to benefit from a recovery in the group and acquisition momentum without the risk of any one partnership falling apart.
Another advantage of investing in an ETF or ETN product is that you don't have to fill out a schedule K-1 for taxes on the MLPs. Any short- or long-term gains are handled just like any other stock. What's more, the 7.3% yield on the fund is more than twice that of other traditional yield investments such as utilities and REITs, which both yield roughly 3.3%.
AMJ's distribution payout has been dropping as MLPs attempted to protect cash flow, but the previous distribution in August was $0.505 per share. With oil prices stabilizing in the $40 to $50 range and natural gas between $2.60 and $3 since May, I expect MLP payouts will start to stabilize as well.
This should bring higher distributions and price appreciation over the long term, but there is a way to boost your income immediately and potentially generate an annual yield of 20%.
The increased volatility across the MLP sector has boosted option premiums. Many investors view options as risky, but one of my favorite strategies is actually considered safe enough for widows and orphans.
How To Boost Your Annual Yield To 20%
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This strategy is known as selling a covered call, and even if you've never traded options before, it's something you can pick up quickly. In fact, you can learn everything you need to know about this strategy in this 90-second video.
With AMJ trading at $30.93 at the time of this writing, we can buy 100 shares and simultaneously sell one AMJ Dec 31 Call, which is trading around $1.05 ($105 per contract). This gives us a net cost of $29.88 per share, which is a 3.4% discount from recent prices.
If AMJ is trading for less than $31 on Dec. 16, traders will keep the $105 premium and their shares, and have the chance to sell more calls. If you were able to sell a covered call with a premium of $1.05 per share every three months, you could earn an additional $4.20 per share a year. When you combine that with the expected annual distribution of about $2, it boosts your yield to 20%.
If the shares close above the $31 strike price at expiration on Dec. 16, our shares will be sold for that price. In this case, we will make $0.07 in capital gains, plus $1.05 for selling the call, as well as the November distribution, which should be around $0.50 based on recent distributions. That gives us a total profit of $1.62 for a 5.4% return on our cost basis of $29.88. Because we'd earn that in 87 days, the annualized return works out to 23%.
As you can see, selling covered calls is as close as it gets to a win-win in investing. It's also one of the most conservative methods of earning extra income available to traders.
If you're interested in earning double-digit yields on high-quality stocks, we've put together a free report detailing how you can start earning an extra $3,000 a month from covered calls. Click here to access it.
This article originally appeared on ProfitableTrading.com: The Turnaround Story With A 20% Yield