Meanwhile, yields aren’t much better on real estate investment trusts (REIT), corporate bonds and other income-oriented fare. The Bloomberg REIT Index yields roughly 120 basis points (1.2 percent) more than 10-year Treasuries, while the yield spread on the average10-year, BBB-rated corporate bond yields is around 200 basis points (2 percent).  

Fortunately, the energy sector offers several alternatives for yield-hungry investors. MLPs and tanker stocks are two of my favorites.

Master Limited Partnerships

MLPs are among the market’s most best long-term performers: The benchmark Alerian MLP Index is up more than 700 percent since its inception; over the same period the S&P 500 is up roughly 130 percent. And prior to the crisis-induced action of 2008, the index’s worst year involved a drop of slightly less than 8 percent.

In 2008 the credit crunch and global recession affected all market sectors to some extent, but MLPs were hit harder than most because of concerns that the credit crunch would prevent the group from raising capital to fund new expansion projects. That year the Alerian MLP Index tumbled 36.8 percent.

But credit conditions eased in early 2009, and fears of major capital constraints never came to fruition. In fact, energy-focused MLPs gained access to credit before many other groups; most MLPs own and operate stable, fee-based assets such as pipelines and storage facilities for natural gas. Last year the Alerian MLP Index soared 76.5 percent.

Fears that Europe’s sovereign-debt crisis would blossom into another credit crunch were blown out of proportion. Several of our favorite names issued bonds or took on new credit lines at the height of the EU credit panic–remarkably, the rates were in line with or slightly lower than last autumn.

Source: Bloomberg

This table lists a number of bonds issued by Enterprise Products Partners LP (NYSE: EPD), one of my favourite MLPs for conservative investors,

On May 20, 2010, Enterprise issued three separate bonds with a total face value of $2 billion.

The most important column in this table is the final one, the yield spread to Treasuries at the time each bond was issued. For example, the bonds maturing on June 1, 2015, yielded 134.5 basis points (1.345 percent) more than equivalent 5-year US Treasury bonds.

For the sake of comparison, I’ve listed other bonds issued by Enterprise over the past two years. The six bonds issued on Oct. 27, 2009, carry much higher yields but aren’t relevant for comparison–these weren’t new bond issues. Enterprise issued these bonds in exchange for TEPPCO Partners’ existing notes when it acquired the firm last year.

The most relevant note is the Oct. 5, 2009, issue of $500 million in 10-year bonds. At the date of issue the bonds yielded 189.9 basis points above US Treasuries, or 5.216 percent. This is significantly higher than the spread on the 10-year bonds Enterprise issued a few days ago. Enterprise’s cost of capital is actually lower than it was last October, long before anyone was talking about a credit contagion in Europe.

The final two bonds on the table are issues from April and December 2008. The former was issued around the time of the Bear Stearns crisis; the latter was issued not long after the height of the 2008 credit crunch. There’s no comparison between the spreads on bonds the MLP issued on May 20 and the two series from 2008: Enterprise’s cost of capital has fallen sharply over the past two years and remains at rock bottom.

In short, the fundamentals remained strong, and fears of a credit freeze were overdone; the selloff represented an outstanding buying opportunity.

Two months later, many readers are asking if it’s too late to invest in our recommended MLPs now that the Alerian MLP Total Return Index has touched new all-time highs. Broadly speaking, MLPs don’t appear to be overvalued; the graph below provides a closer look.

Source: Bloomberg

At present, the Alerian MLP Index yields roughly 6.7 percent, down nearly 100 basis points (1 percent) from its May lows. This doesn’t mean that MLPs have cut their payouts; rather, the rally in the Alerian MLP Index caused the yield to decline. With the yield on a 10-year US Treasury at about 3 percent, the Alerian MLP Index offers slightly less than 400 basis points (4 percent) more yield than the 10-year Treasury.  

The average yield spread for the Alerian MLP Index over the four-year period covered in the graph is 363 basis points; the index offers a significantly higher-than-average yield spread to Treasuries. In other words, investors are being paid more to hold MLPs than would normally be the case.

Also, note that the financial crisis of 2008 and early 2009 skews this average higher. During the credit freeze, investors flocked to US government bonds as a safe haven, pushing the yield on the 10-year Treasury down to around 2 percent at its lows in late 2008.

At the same time, investors indiscriminately sold stocks to raise cash, propelling the yield on the Alerian MLP Index to as high as 12 percent. Even rock-solid MLPs that have consistently raised their distributions yielded in excess of 10 percent at their lows.

If we exclude the period from mid-August 2008 to mid-April 2009, the average yield spread for the Alerian MLP Index drops to less than 300 basis points. On that basis, the current yield on the Alerian looks even more attractive.

And yields offered by traditional income-producing groups are far less enticing.

The Bloomberg REIT Index currently yields about 114 basis points over 10-year Treasuries, less than one-third the spread offered by the Alerian MLP Index. From 2006 to 2010, the average yield spread for REITs is just shy of 140 basis points; the Bloomberg REIT Index offers a lower-than-average spread to Treasuries.

Meanwhile, the yield on BBB-rated industrial bonds is about 235 basis points, while the four-year average is 2.62. Remember that these figures and graphs are based on average yields: plenty of MLPs have strong growth prospects and yield 10 percent or higher.

Simply put, the Alerian MLP Index offers an attractive yield relative to historical norms and compared to other income-producing groups. And the group offers another thing many income-oriented investments do not: significant growth potential.

Most MLPs own midstream-energy assets such as pipelines, storage facilities and gas- processing plants–operations that produce steady cash flows and are somewhat insulated from economic conditions and commodity price. For example, partnerships usually sign long-term deals that guarantee minimum payments from. In other words, many MLPs get paid whether their customers use the pipeline or not.

And rates charged for transporting commodities have nothing to do with prices; the pipeline operator doesn’t care whether gas transported through its pipes trades for $2 or $10 per million British thermal units.

Energy-focused MLPs generally have two avenues for growth.

First, the development of America’s vast onshore shale gas and oil reserves requires the build-out of a huge amount of infrastructure–for example, pipelines to transport the gas from new fields, greater storage capacity to handle all of the gas produced and processing plants to remove valuable natural gas liquids (NGLs) from raw natural gas. Without this basic infrastructure, the shale-gas revolution will stall.

Second, many of our favorite MLPs continue to acquire new assets at good prices. Refined products pipeline operator Magellan Midstream Partners LP (NYSE: MMP) announced that it will acquire oil storage facilities and oil pipelines for $289 million from BP Pipelines, a midstream energy unit of BP (NYSE: BP). This makes Magellan one of the first companies to benefit from BP’s struggles in the Gulf of Mexico.

Integrated oil companies such as BP and Conoco Phillips (NYSE: COP) own significant midstream energy assets that fit perfectly within the MLP structure.

Midstream assets generate dependable cash flows but don’t grow production. The market values most integrated oil firms based on their ability to grow oil or gas production; it makes strategic sense for the majors to sell off midstream assets and deploy the capital in exploration and production projects. And because MLPs don’t pay any tax at the corporate level, these cash-generative assets are far more tax efficient when held within an MLP structure.

Meanwhile, the cash flows generated by such assets are just what MLPs need to back up their generous distributions to unitholders. 

For years integrated oils have sold midstream energy assets to MLPs. But BP’s challenges and desire to raise $10 billion in cash via asset sales over the next year likely accelerated these plans; Magellan took advantage by picking up outstanding assets at a good price.

Investors interested in the group can click here to sign up for a free trial of MLP Profits. The publication includes proprietary ratings of every publicly traded MLP as well as model portfolios containing our favorites for conservative, aggressive and growth-oriented investors.

Tanker Stocks

The oil tanker business is notoriously volatile because tanker rates fluctuate with demand for oil and the availability of ships.

Nonetheless, with global oil demand recovering, I expect the back half of the year to be a solid environment for tanker companies. Moreover, many stocks in the group offer substantial dividend yields–a great source of returns amid volatile and uncertain market conditions.

Note that tanker companies don’t make money from rising oil prices. Tanker rates have no direct relationship whatsoever to energy prices; rates depend on demand for oil transport. Demand for oil transport can rise for a number of reasons, but the two most important single factors to watch are OPEC oil output and global oil demand.

Let’s start with a brief look at demand. As most investors are well aware, US oil demand collapsed during the 2008-09 recession. But weekly data from the Energy Information Administration indicates that US oil demand is up roughly 3 percent from a year ago, led by a nearly 11 percent year-over-year jump in jet fuel demand.

Meanwhile, the International Energy Agency (IEA)recently announced preliminary findings showing that China has overtaken the US to become the world’s largest energy consumer. If the media attention this story received is any indication, the announcement surprised many. And the news clearly troubled Chinese authorities, who quickly questioned the credibility of the IEA’s data.

Longtime readers shouldn’t have been taken aback by the news; one of the most important and longest-standing themes of The Energy Letter is the growing importance of emerging markets such as China and India to the global energy puzzle. Chinese authorities were quick to downplay this news because the country has come under fire, primarily in the West, for using too much energy and producing too much pollution.

The West’s cavils appear increasingly hypocritical. After all, the US and all other developed countries built their economic might on energy produced primarily from fossil fuels. Pundits forget that US and Western European energy consumption rose exponentially alongside disposable income in the early 20th century. A similar phenomenon occurred in Japan and South Korea during the latter half of the century. It’s only natural that consumers in today’s emerging markets would wish to reap the same benefits.

Chinese oil imports have trended steadily higher after a brief dip at the height of the 2008-09 credit crunch and global recession.

Some subscribers ask if Chinese data on oil imports is reliable. Whether or not you believe Chinese data is reliable, these statistics are backed up by data on tanker fixings; a lot of tankers headed from the Persian Gulf to the Far East. According to the most recent data, about 70 percent of all tankers chartered to transport oil from the Middle East are headed to the Far East–a staggeringly large percentage.

And tankers chartered in West Africa or South America traditionally head to the US because the distance is shorter. But tankers booked in these markets increasingly head east, a sign that growth in global oil demand is originating from that region.

Because major oil consumers such as the US and China are also big importers, strengthening global oil demand spells rising rates for tanker shipping services.

The other key factor to watch is OPEC oil production. Much of the oil produced by large, non-OPEC oil producers such as the US and Russia is shipped by pipeline rather than by ship. In contrast, roughly 90 percent of all oil produced in OPEC is shipped on tankers; an uptick in OPEC oil production means a lot more for tanker demand than rising non-OPEC output.

When OPEC increases its output quotas, tanker companies reap the benefits. OPEC sets output limits for all of its members in an effort to control global oil supply and stabilize profits. Accordingly, OPEC nations hold spare capacity–idled oil wells and fields that can return to production within a month and sustain output for a lengthy period.

Readers often ask why crude oil prices tend to rise when OPEC increases output and fall when these nations cut their quotas. After all, logic would seem to dictate that rising OPEC output would spell higher oil supplies and, therefore, weaker prices.

But oftentimes the oil market focuses on the level of spare capacity rather than actual production. When OPEC boosts quotas, member states are effectively reducing their spare production capacity in an effort to supply more oil to global markets.

Spare capacity is a sort of cushion for global oil demand–it represents an overhang of oil supply than can be used to balance global oil markets as needed. Falling spare capacity, therefore, means less of a cushion and higher prices.

Rising OPEC quotas and output is also bullish for tankers. Producers in the region tend to use the largest class of tanker ship–very large crude carriers (VLCC)–to transport oil to markets in the Far East or to the US. When OPEC’s output is on the rise, demand for tankers increases. 

There’s also a distinction between official OPEC quotas and actual oil production. That is, many OPEC producers cheat by producing and selling more oil. According to the most recent data, OPEC countries are producing slightly less than 27 million barrels of oil per day–around 2 million barrels of oil over the official quota. Average compliance stands at 55 percent, well off levels of 70 to 80 percent that prevailed in the first half of 2009.

Although the organization undoubtedly would prefer that its member states adhere to the quota, noncompliance was somewhat of a given in the current environment. In early 2009 crude oil prices dipped into USD30 range, a level at which many nations simply can’t produce oil profitably. In short, fear made member countries more likely to follow through with the major output reductions OPEC announced when oil prices collapsed in the latter half of 2008 and early 2009.

But crude oil prices stand in the USD75 to USD80 range and almost reached USD90 earlier this year; it’s tempting for countries to produce a bit more and realize extra profit from export sales.

The bottom line: While OPEC hasn’t raised its official quota, the cartel’s de facto output has increased by roughly 2 million barrels per day–good news for tanker companies.

I expect OPEC to make this de facto hike in output official at some point. Given the increase in global oil demand, such a move could occur toward the end of 2010 or early in 2011. This would be a major upside catalyst for tanker rates and related stocks.

Here’s a look at the Baltic Dirty Index, a good indicator for tracking average spot rates for a wide range of tanker sizes that travel an array of routes.

Source: Bloomberg

As you can see, tanker rates evince a clear seasonal pattern: Rates tend to rise in the winter and slump in summer. But tanker rates were at depressed levels for much of 2009 and have increased counter-seasonally in recent weeks–a sign of underlying strength.

And with tanker rates still low by historic standards, now looks like a great time to jump into the sector ahead of the normal seasonal run-up in the final 4 to 5 months of the year. Some of the best-placed tanker operators currently yield around 8 to 9 percent.

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