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2 Stocks, 2 MLPs to Best Play Oil

April 29, 2015 – by Richard Band

What’s the most undervalued asset in the world today? My vote goes to crude oil. Six years ago, when West Texas Intermediate last traded around $55 a barrel, the S&P 500 stock index was less than half today’s level. Gold was nearly 25% lower than it is now. Home prices were almost 20% lower.

gas prices

Source: Flickr

Not only is oil cheap relative to other assets, but it’s also underpriced relative to what may be the most important metric of all in the long run: replacement cost. As I’ve pointed out before, petroleum experts estimate that, globally, the marginal cost of exploring for, and lifting, a barrel of crude runs north of $80.

Sure, there are individual producers and even whole countries (like Saudi Arabia) with much lower costs. But even if those folks pumped at full tilt — round the clock, every day of the year — they couldn’t supply the whole world.

Simply put, if the price of crude doesn’t bounce back to $80 within fairly short order (a year or so), huge swaths of the globe’s oil production will shut down. Then you’ll see price increases that will make you cringe.

Already, according to Baker Hughes, the North American drilling-rig count has plummeted 49% from its 2014 peak. By the end of the second quarter, it should be clear that U.S. oil production is falling.

Bottom line: I’m confident that oil prices won’t remain at the current low ebb for long. However, I don’t know (and neither does anybody else) exactly what recovery path “black gold” will follow.

In the face of such uncertainty, I advise you to make your investment moves cautiously — at least until the oil price settles into a clear uptrend. There will be plenty of time to speculate (if you wish) on shale plays or deepwater drillers. For now, focus on collecting as much of your cash payout as you can, as soon as you can — in the form of dividends.

Start With the Major Oil Stocks

The oil majors I’ve recommended in the past give you a good place to start. Be careful not to overpay, though. A stock like BP plc (ADR) (NYSE:BP), for example, stands almost 22% above its mid-December low, even though the price of WTI crude remains pretty much in line with its December bottom.

At the moment, my top buy among the majors is Exxon Mobil Corporation (NYSE:XOM). XOM boasts the industry’s safest dividend, and Exxon Mobil stock isn’t far off its 52-week low. XOM stock’s current yield is 3.1%.

Royal Dutch Shell plc (ADR) (NYSE:RDS.A), the other international oil stock to buy, offers a higher dividend yield and greater appreciation potential than Exxon Mobil but also carries some added risks. On April 8, Shell announced a monster $70 billion takeover bid for BG Group, parent of British Gas. It’s a bold but expensive move: Shell is offering a blend of cash and stock initially valued at a 50% premium to BG’s share price on the eve of the bid.

By slashing capital spending for the combined entity, selling $30 billion of assets and squeezing out $1 billion a year of operating costs, Shell believes it can maintain the dividend at the current rate. In addition, CEO Ben van Beurden has pledged to buy back $25 billion of stock during 2017 – 2020, assuming (reasonably, I think) that the price of oil returns to at least $70 a barrel.

I like Shell’s new strategic positioning, which will make Shell far and away the world’s largest producer of liquefied natural gas — a high-value fuel with a growing, worldwide market. However, success will depend heavily on van Beurden’s execution skills. Shell’s current yield is 6%.

Infrastructure for Income and Growth

In today’s distressed environment for oil prices, I don’t recommend any pure domestic producers. However, certain infrastructure providers still offer ample cash income up front, together with the prospect of capital appreciation later on as America’s energy industry gets back its growth groove.

Typically, the strongest and safest infrastructure companies run pipelines; facilities for gathering and processing natural gas; and terminals for storing crude oil, natural gas and various refined petroleum products. A few of these outfits are organized as ordinary taxpaying corporations, but most take the form of master limited partnerships.

MLPs pay little or nothing in corporate income tax. Instead, they “pass through” their incomes and deductions to the limited partners (you and me). This special tax status enables MLPs to dish out handsome quarterly cash distributions. Usually, an MLP’s deductions allow you to defer tax on the bulk of your cash distributions for many years — sometimes a decade or more.

The main drawback to MLPs is extra paperwork they create at tax time. A glitch in the tax law also makes them generally unsuitable for retirement accounts. Despite these obstacles, though, individual MLPs can toss off eye-popping returns.

My favorite, at the moment, is conservatively financed Plains All American Pipeline, L.P. (NYSE:PAA). PAA yields 5.4%, and I look for the partnership to more than double its payout over the next decade — a great setup for investors just entering retirement.

With an MLP fund, you drastically reduce the tax complications. (MLP funds issue a simple Form 1099 each year, rather than a complex K-1.) Dividends from an MLP fund generally qualify for the low federal tax rate or may even be treated, in part, as a tax-deferred return of capital.

My top-pick MLP fund right now is closed-end Tortoise Energy Infrastructure Corp. (NYSE:TYG), yielding 6%. Suitable for IRAs.

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.

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