Profits from the High-Yield Energy Sector Without Those Pesky K-1s

Energy Investing, K-1 Investing, Master Limited Partnerships (MLPs)

With each quarterly earnings season, it becomes clearer that the recovery in energy infrastructure stocks is underway. This is a sector that has been out of favor with investors since the early months of 2015.

The continuing North American growth of crude oil and natural gas production is starting to be realized in the values of those companies that move energy products from the well head all the way to the end user. Investors now have more investment choices that do not come with the tax complicating Schedule K-1.

Since the early 1990’s most of independent energy infrastructure assets have been owned by publicly traded master limited partnerships (MLPs). These partnerships are tax efficient for the ownership of high cost, long life assets like pipelines, processing plants, storage facilities and energy product terminals. The tax advantages of depreciable assets get passed through to the owners of MLP limited partner units.

MLPs were also known for paying attractive yields, with the distributions classified as non-taxable return of capital. The trade off for investors was the extra work at tax time to report partnership results from the Schedule K-1 sent out by the MLP to LP unit holders.

Up until the second half of 2014, the MLP sector was on a steep growth trajectory. Companies where building more energy infrastructure assets. As those assets started to generate revenue, the LP distributions were increased and MLP unit values marched steadily higher. MLPs handily outperformed the overall stock market.

At the end of 2014 and through the next year into early 2016, energy commodity prices, especially crude oil, crashed. The entire energy sector of the stock market crashed, including the previously viewed as safe MLPs and corporate pipeline companies.

The crash also cracked the MLP business model, which turned out to be over leveraged and paying out too much of free cash flow as distributions. These companies could not issue equity to pay for growth projects and the revenues on already owned assets started to fall. The sector was pushed into several waves of financial restructuring. These restructurings included asset sales and, in many cases, steep distribution cuts.

Related: Buy These 3 High-Yield Restructured Energy Stocks

As part of rebalancing their finances, a number of energy infrastructure companies decided the MLP model no longer was the right structure. Partnerships with corporate sponsors/general partners were merged into the corporations. The depreciation on assets shields the corporate cash flow from corporate income tax. Other companies offer a parallel publicly traded business that tax reports on IRS Form 1099. There is a belief in the sector that more investors will be attracted to 1099 stocks, compared to K-1 reporting investments. Also, K-1 investments can cause tax problems if the shares/units are owned in a tax-qualified account such as an IRA.

One positive outcome of the problems experienced by the energy infrastructure companies over the last three years is that investors now have a greater selection of 1099 reporting stocks to choose from, if that is there preference.

Here are three such stocks with attractive yields and strong dividend growth prospects.

In early 2018 Williams Companies (WMB) just announced it would buy up the 26% of Williams Partners L.P. (WPZ) that it does not own. WPZ was the MLP controlled by WMB. The buy-in was finalized in August of last year.

Now, as a stand-alone corporation, Williams is primarily a natural gas and natural gas liquids (NGLs) services company. It owns the largest volume and fastest growing interstate pipeline system in the U.S., connecting the best supplies of natural gas and natural gas products to the best markets. The company owns over 33,000 miles of pipeline.

With the elimination of its MLP, Williams now has a much stronger income statement. Cash flow coverage will b 1.7 times the dividends, which is very strong in this sector.

Management has indicated they expect the WMB dividend to grow by 5% to 6% per year.

WMB shares currently yield 5.6%.

Targa Resources Corp (NYSE: TRGP) provides natural gas and NGL services primarily to the high production growth Permian energy play.

Targa engages in gathering, compressing, treating, processing, and selling natural gas, as well as in storing, fractionating, treating, transporting, terminaling, and selling NGLs, NGL products, refined petroleum products, and crude oil.

The company also sells propane and provides related logistics services to multi-state retailers, independent retailers, and other end-users.

Targa was one of the first corporate sponsors to absorb its controlled MLP. That allowed the company to continue paying a steady dividend while others were reducing their payouts to investor.

The dividend has been level since the start of 2016, with prospects for a return to dividend growth in 2020.

The shares yield 8.6%.

Equitrans Midstream Corporation (ETRN) is a newly created midstream assets owning corporation that was spun-out in November 2018 by upstream energy producer EQT Corporation (EQT).

With the spin-off, the new company received all the EQT Midstream Partners (EQM) and EQT GP Holdings LP (EQGP) LP and GP units owned by EQT. EQGP owned the general partner incentive distribution rights (IDR) interest in EQM.

After it became a public company, ETRN made an offer and completed the purchase of all outstanding EQGP units. In early 2019, ETRN retired the IDRs in exchange for additional EQM units.

Now that the dust has settled, EQM is a natural gas processing and pipeline owning MLP. ETRN is a corporation whose assets consist of EQM units. ETRN is a 1099 reporting midstream corporation.

The company forecasts 6% to 8% annual dividend growth and the stock currently yields 8.4%.

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