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Steve's note: Contributing today's essay is my colleague Chris Mayer. As usual, Chris has found a contrarian way to play a huge theme in the market right now...

An Extraordinary Income Opportunity in the Energy Market

By Chris Mayer, editor, Capital & Crisis
Saturday, July 12, 2008

Unless you've been without any form of human contact for the past five years, you're probably aware energy investors are getting rich right now.

As an advisor to thousands of investors, I've been fortunate to be "heavy" in energy for the past few years. Most of my recommendations in this sector are turning in ridiculous returns... 50%... 100%... even 200% in less than a few years.

For the most part, I've stuck with small, undiscovered oil and gas producers. These tend to get little analyst coverage, so you can find plenty of cheap stocks with upside potential. I'm also a big fan of oil services... the companies that do all the little things needed to get oil from the ground to your gas tank. (You can read my argument for these stocks here.)

But what about folks interested in high income from their investments? I've got great news for you. You see, problems in the U.S. credit markets recently created a fantastic income opportunity in the energy markets. It all comes down to a problem with finding energy in the first place...

Discovering lots of oil and gas is great. There is one hitch, though. You have to get it to market. You have to bring it to the consumers. Hence, we are experiencing a boom in getting oil and gas from Point A to Point B. That means lots of pipelines. Miles and miles of pipelines.

Big pipeline projects are in the works all over North America. Recently, oil behemoths ConocoPhillips and BP approved a $25 billion project to build a pipeline from Alaska to Canada and the lower 48. It will be the largest private-sector pipeline built in North America.

In the southeastern U.S., over 25 pipeline projects are in the works. In the Rockies, a group of companies plans a 1,678-mile pipeline – the longest ever.

Such a beehive of projects and ambition led Phil Wright, president of the Gas Pipeline division of Williams, to say "[Pipeline construction] is at the highest level I've seen in 30 years." One energy observer said: "What we are seeing is the biggest global boom in steel pipes for at least 40 years." Bentek Energy, a consulting firm, topped 'em both, writing that it's the busiest time for pipelines since the 1950s. When you've got the graybeards trying to top each other for how far back you have to go to find an equivalent, you know you're onto something special.

But it all makes sense. As we venture out to more remote areas, we have to build the infrastructure to follow. New sources of supply drive the need for pipelines. Pipelines are like the roads and highways of the energy world.

That's why I like investments in the companies that own and build pipelines. They pay high yields, based on a growing stream of fees earned from their pipeline assets. They're like toll operators, collecting cash as oil and gas flow through their pipelines. These investments are usually structured as "MLPs."

An MLP allows a company to avoid paying income taxes as long as it pays out the bulk of its earnings to its shareholders (unitholders). MLPs are like lesser-known cousins of real estate investment trusts (REITs).

MLPs, as a group, were hit hard in the credit crisis. The Alerian MLP Index – a common benchmark for this species of financial fish – fell 20% off its high. The 7% fall in March was the worst monthly decline the index has ever suffered (it's still near those selloff levels).

Since MLPs pay out most of their earnings in cash, they depend on access to the credit and equity markets to fund any large expansion efforts. So, the market reasons, since the credit markets shut down, it will be harder for MLPs to grow.

Of course, some MLPs are in better shape than others. And in the grand scheme of things, I think the credit markets will look more favorably toward financing the tangible assets and cash flow of pipelines than funky mortgages. Besides the credit crisis concerns, a lot of new MLPs have been hitting the market. It will take some time for the market to digest all that supply – probably six months or so.

They were great investments then... And thanks to the recent credit problems, they're great investments now. If you're looking to add some energy to your income portfolio, it's a good time to check out MLPs.In any event, the selloff creates a rare opportunity to grab them cheap. The yield on the Alerian MLP Index went over 7% recently. That's nearly four points above the 10-year Treasury. The widest gap ever was 4.25 points, back in November 2002. After that, they doubled over the next five years while paying higher and higher distributions.

Good investing,

Chris Mayer

P.S. I dedicated the June issue of Capital & Crisis to what I believe is the best MLP opportunity in the market today. This company has a fantastic collection of pipeline assets... which you can buy for less than its replacement cost. It also has a safe yield close to 10% and a lot of potential upside.

I think you have a good shot at a 45%-50%-plus total return over the next 12-18 months. You can learn more about Capital & Crisis here.

Market Notes


This week's chart shows the MLP correction Chris Mayer describes. It's the past year in the benchmark Alerian MLP Index.

MLPs enjoyed a big rally last year. They got a little "ahead of themselves"... so the credit crunch served up a 20% correction in these boring stocks. Given the bullish case here, this correction is offering income investors a gift.

Most U.S. pipelines transport natural gas – the "clean cousin" of coal and crude oil. We guess the rising green movement will provide a strong tailwind for this fuel and the infrastructure that goes with it... a tailwind that will boost cash flows and asset prices for MLPs. 

– Brian Hunt 

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