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Future historians may well define our current time on Earth
as the "oil age."
It is estimated that the world consumes 80-85 million
barrels of oil per day. And as industrialization expands
across the globe on an unprecedented scale, long-term demand
is on the rise.
Over the past year, however, the price of oil has fallen.
The financial crisis and worldwide recession caused oil
prices to plummet from a high of about $147 per barrel last
summer all the way to $34.
But, things are changing. As panic from the financial crisis
has ebbed, crude oil prices have already begun to rise,
doubling to $67 per barrel today. In fact, Goldman Sachs
revised oil price forecasts from a previous $45 per barrel
in 2009 to $85 per barrel by the end of 2009 and $95 by the
end of 2010.
But if you're an income investor, how can you turn black
gold into high income? You can't do it with the major oil
companies. ExxonMobil (NYSE: XOM) is only yielding about
2.3% and Chevron (NYSE: CVX) only yields about 3.8%.
Instead, you need to expand your options...
I've found three areas investors can use to supercharge
their income by earning double-digit yields -- all powered
by black gold.
Oil Income Play #1: Canadian Trusts -- Yields of 10% or
More
Our first stop for income from oil is a land where the
yields are ripe, luscious and double-digit -- and it's just
north of the border. Canadian royalty trusts are oil and gas
producers that typically pay sky-high distributions. They
are able to pay high yields because they don't have to pay
corporate income taxes if they distribute the bulk of their
income to unitholders. Many of these trusts are currently
paying as high as 10% to 14%. For example, Penn West
(NYSE: PWE) pays an 11.5% yield.
Even though they are found in Canada, it's easy as pie for
stateside investors to buy Canadian trusts. Many trade right
on the NYSE. You can buy them just as easily as buying a
common stock.
The distributions from the trusts typically qualify for the
15% maximum tax rate. While there is a 15% Canadian
withholding tax, you can claim this as a foreign tax credit.
In addition, distributions are usually paid in Canadian
dollars. If the U.S. dollar falls against the Canadian
dollar (which it has by more than -15%since March), your
distributions rise when converted into U.S. dollars --
boosting your income without the trust even raising its
payment.
Oil Income Play #2: Master Limited Partnerships --
Steadily Rising Income
If you want to trade in a few points of income for steadily
rising payments, then master limited partnerships are what
you're looking for. This asset class still offers high yields,
but it's famous for consistently raising payments to
investors. Well-known MLP Kinder Morgan (NYSE: KMP)
paid just $0.475 per share each quarter in 2001... but now
pays $1.05 every quarter.
Most MLPs are in the energy arena. A majority make their
money by owning oil and gas pipelines and processing
facilities. They essentially act as toll roads -- receiving
a fee based on the amount of volume shipped via their
network.
MLPs allow for "pass-through" income. This means that
they're not subject to corporate income taxes. The result is
that more cash is available for distributions than would be
available if the company had incorporated.
Most MLP distributions are comprised of about 20% net income
and 80% return of capital (which is really just an allowance
for depletion or depreciation).
The income portion is generally taxed at your ordinary
income tax rate. Return of capital distributions lead to a
reduction in your cost basis, meaning you don't pay taxes on
the return of capital portion until you sell the security,
making MLPs ideal for long-term investors.
There is one glitch with MLPs. Individual MLPs aren't
suitable for individual retirement or other tax-deferred
accounts because they generate a type of income called
"unrelated business taxable income" (UTBI). If your
retirement account earns more than $1,000 of this income,
then you'll end up paying taxes on it. As a result, you
probably want to hold MLPs in a regular brokerage account.
Oil Income Play #3: Closed-End Funds -- Professional
Management
If you're looking to earn high yields from oil and
enjoy
professional management, then my third find is the perfect
match.
With closed-end funds focused on oil and energy, you'll own
a share of a vast portfolio of stocks that would be nearly
impossible to select and amass yourself. Also, funds have
the resources and expertise to search every corner of the
globe for the best opportunities.
Many funds even use techniques like writing call options to
boost their yields for investors. It's no surprise then that
I've found more than 20 funds focused on the energy sector
yielding above 6%.
Taxation of funds will vary from fund to fund, depending on
where its income is sourced. But in some cases funds they
can actually make taxes easier. For instance, the the
Kayne Anderson Energy Total Return Fund (NYSE: KYE)
invests in a basket of master limited partnerships. The fund
takes care of the UTBI problem mentioned above -- and
actually makes tax time smoother for investors.
Good Investing!
Tom Hutchison
Carla Pasternak's Dividend Opportunities
P.S. -- My friend and colleague Carla Pasternak has an
entire section of her "Dividend Optimizer" Portfolio
dedicated to MLPs. To see her latest holdings you have to be
a subscriber. To learn more,
visit this link.
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