High Yields from Low Expectations

A few days ago, my colleague Scott Chan asked “Are MLPs Right for You?” As Scott noted, the tax treatment of distributions from a master limited partnership (MLP) can be complicated.

The original purpose for giving MLPs special tax treatment was to encourage investment in our nation’s infrastructure. Most MLPs are in the energy, real estate, and agriculture sectors. They own assets that facilitate commerce in those goods.

The preferred tax treatment for MLPs is attractive. Most or all of the distributions are tax-deferred and can sometimes be avoided altogether upon death by virtue of a stepped-up cost basis.

However, the tax benefits of an MLP should not be the sole reason for owning one. After all, what good is a tax-deferred dividend if the value of the company is gradually deteriorating?

That’s why you need to take a hard look at the underlying business of an MLP. Especially if the assets it holds are depleting and may soon be exhausted.

That fear has discouraged some investors from owning MLPs in the energy sector. Their concern is not only the finite supply of hydrocarbons that will one day run out.

They also worry about the impact electric vehicles (EVs) will have on demand for gasoline. According to the U.S. Energy Information Administration (EIA), “consumption of finished motor gasoline” accounted for “about 43% of total U.S. petroleum consumption” last year.

Without a doubt, eliminating that much demand from the petroleum market would send oil prices plummeting. The problem with that theory is that it could be a long time until that possibility will become a reality.

In the meantime, there is a lot of money to be made in energy sector MLPs. Here is one of my favorites.

Enterprise Products Partners

Houston-based Enterprise Products Partners (NYSE: EPD) is one of the most valuable energy sector MLPs in the world, with a market cap of roughly $62 billion. As a midstream MLP it owns the pipelines, storage facilities, and vehicles necessary to move raw petroleum to refineries.

That may not sound exciting, but it is big business. During the first quarter of this year, EPD generated $2.1 billion of adjusted cash flow from operations (CFFO) from which distributions are paid.

According to the company, it “is the only midstream company to grow Adjusted CFFO per Unit and reduce unit count without material asset sales.” In other words, it isn’t heating the house by burning the furniture.

Last year, EPD paid out 56% of its adjusted CFFO to its unitholders in the form of distributions and share repurchases. It also raised its annual distribution for the 25th consecutive year, making Enterprise Products Partners a Dividend Aristocrat.

Its current quarterly cash distribution of $0.515 per unit equates to a forward annual dividend yield of 7.3%. In addition, its unit price has appreciated 20% over the past two years for a total return (share price appreciation plus dividends paid) of approximately 40% over that span.

I expect that trend to continue. According to the EIA, “global consumption of liquid fuels will increase by 1.1 million b/d (barrels per day) in 2024 and 1.5 million b/d in 2025.”

The EIA further notes, “Most of the expected growth is from non-OECD (Organization for Economic Cooperation and Development) countries.” In short, rapidly expanding middle class populations in Asia will be buying a lot of vehicles that use gasoline over the remainder of this decade.

That’s why I don’t worry about the immediate impact that the EV market will have on energy sector MLPs. In fact, I don’t believe it will become a serious threat for at least another decade, perhaps longer.

Maximizing Cash Flow

Even though the existential threat of EVs to energy sector MLPs is a long way off, it does limit their long-term upside potential. That is one reason why only 25% of EPD’s units are held by institutional investors.

Another reason is the low ESG (environmental, social, and governance) scores of most energy sector MLPs. Many pension funds and other institutional shareholders will not invest in companies with low ESG scores.

That is bad news for growth investors that prioritize share price appreciation over dividends. But it is good news for income investors that want to maximize cash flow.

Another way income investors can increase current cash flow is by using an options strategy known as covered call writing. That technique allows them to sell the future capital appreciation potential of a stock (or MLP) to a speculator in exchange for a fee.

For example, at the start of this week while EPD was trading at $28.50, the call option that expires on December 20 at the $30 strike price could be sold for 40 cents per unit.

If EPD rises above $30 before this option expires, then your units would be called away from you at that price. In that case, the total return on this trade over the next six months would be 6.7%, or 13.4% on an annualized basis.

If EPD never gets above $30 by the time this option expires, then the money you received for writing that option is yours to keep without any further obligation. In fact, you could turn around and write another option against the same units if you wanted to.