These energy investments spin out attractive income, even as oil prices have fallen

Published Wed, Jul 5 20231:21 PM EDT

Last year's superstar asset – oil – is getting left in the dust as stocks roar in 2023, but there's still an energy play for investors who are focused on income. Indeed, the S & P 500 is up nearly 16% this year, while West Texas Intermediate crude is off by nearly 11%. Energy stocks are also this year's underdogs, with the S & P sector down more than 7%. However, a pocket of income potential has emerged in the form of master limited partnerships. These partnerships, which focus on the processing and transportation of oil and gas, trade like stocks. Better still, they offer yields exceeding 6%. "It definitely remains an attractive space for income-oriented investors," said Stephen Ellis, an energy and utilities strategist at Morningstar Research Services. He warned that the growth in the space might not be as strong as it had been in previous years. "Primarily, it's because U.S. oil and gas production isn't growing to the extent it was in the past," he said. Rather, U.S. producers have pulled back their growth in favor of returning cash flow to shareholders in the form of distributions and share buybacks, Ellis added. But for discerning investors, the opportunity for growth and dividend income awaits. Ellis highlighted Energy Transfer and Equitrans Midstream , which offer yields of 9.6% and 6.3%, respectively. Not like your other yield payers MLPs trade on an exchange like stocks, and they are subject to volatility – especially if energy prices swing dramatically – but their structure is different from that of C-corporations. MLPs are managed by general partners who run the business, while limited partners – the investors – purchase interest in the partnership and feed it capital. In turn, the limited partners collect income distributions from the business. MLPs aren't subject to federal income taxes, but the limited partners are responsible for levies on the income they receive. This feature allows the partnership to pay a good yield. The tax treatment also varies from what you might see in a C-corp that offers dividends. In that case, the C-corp pays corporate income taxes and the shareholders are responsible for levies on dividends they get. Tax hurdles Attractive income aside, investors need to be on the lookout for where they keep these MLPs. "I don't want my clients paying more taxes than they need to, so asset location is very important," said George Gagliardi, certified financial planner and financial advisor at Coromandel Wealth Management. That's because if you keep these assets in an individual retirement account or a 401(k), you could trigger a surprise tax liability, known as unrelated business taxable income. In that case, your retirement account is subject to taxes. Each year, you'll also get a Schedule K-1 from the MLP, stating the income you received from the partnership. You'll need this form to submit your tax return to the Internal Revenue Service, which means if the K-1 is delayed, your tax filing season may go a little longer than you'd like. That means as you figure out whether MLPs are the best fit for your scenario, consider how taxes might affect the yield you ultimately take home. "People see these high yields and get really hungry," said Gagliardi. "The gotchas here are the taxes, and you have to factor them in."