It's a tricky market out there for energy investors.
Even though opportunity abounds, there are plenty of factors driving ordinary investors away from the market, like global political tensions, ongoing concerns about available supplies, credit limitations for producers, increased volatility on the derivatives markets, and rising global demand.
There's a lot of noise, and short-term irrationality is trumping fundamentals.
But even amid the confusion, we know one thing for sure.
The price of oil is going to accelerate.
As Kent said on Monday, we have a very different dynamic taking place in the markets from the events of 2008. Three years ago, speculation drove oil prices, but an outside crisis decimated the global markets (namely, the subprime mortgage mess and the corresponding credit freeze).
But this time, we're experiencing a constriction produced by a significant cutback in new oil drilling. With greater unconventional production in the cards and greater concerns about the availability of supply, we're witnessing a perfectly predictable storm of events that will drive prices higher.
Still there's one thing that Kent and I continue to stress before you go out and start buying up energy stocks. That's this:
Rising oil prices will not drive similar performances in all energy companies.
You need to grasp an overall strategy to profit this time around.
The lack of cheap supplies and the cost of procurement in unconventional sources are major concerns. So is the acceleration in short-term swings in volatility. We are entering a period of boosted unconventional oil and gas production to tackle these challenges.
Access to unconventional sources has set off an energy boom here in the United States, as new technologies have enabled this country to greatly improve its oil and gas sourcing. Moving forward, the United States will look to its oil and gas shale plays and to source an expanding fuel supply from our neighbor to the north: Canada.
But it won't be cheap to do this, especially while increased swings in volatility become the norm.
So what's the best way to play volatility while managing your risk?
There's Always Money in the Midstream
The best lesson I've learned came when I first met Kent last year at an investment conference. Few people caught this because they were too focused on the names of the companies he was discussing, and not on the strategy.
He said that he told his graduate students that it didn't matter if the price of oil was going up or down in the short term. So long as you plant yourself in the middle of the supply chain, you're going to make some money.
We've talked a lot about this in the past, but it's worth stressing because it's part of a greater strategy.
Interest continues to swell in master limited partnerships (MLPs)—partnerships that are publicly traded on a securities exchange. These midstream companies connect the upstream producers of oil and gas to the downstream refiners and retail companies.
In energy, these MLPs are structured in various ways, but essentially comprise companies that own and operate storage facilities, pipelines and terminals for oil and gas. An MLP provides the storage and distribution, while the operating companies and other users pay fees.
Those fees may be for the transport of oil or gas. But in the case of gas, much of the pipeline system really ends up being used for storage purposes. For most parties, unused gas is a discounted asset. But if you are the entity being paid for the storage space, it is a continuing source of revenue.
Until recently, the plays here have been in single entities—Plains All American Pipeline (NYSE:PAA), Spectra Energy Partners (NYSE:SEP) or Chesapeake Midstream Partners (NYSE:CHKM), for example.
But there are other ways to get in on the action, all while capturing the opportunity for share appreciation and strong dividend returns. There are now more than 20 sufficiently liquid exchange-traded vehicles providing entry into a large number of MLPs. All of them provide a combination of oil and gas plays in storage, pipelines, and terminals.
But the best option has been the JP Morgan Alerian MLP Index ETN (NYSE:AMJ).
This exchange-traded note offers exposure to the Alerian MLP Index—a market-cap weighted, float-adjusted index established to provide investors with the ability to track the entire oil and gas MLP sector.
The Alerian Fund is balanced a bit more toward pipelines. And it's balanced slightly more toward gas than oil, compared to other major ETN competitors.
Even though we are looking for more of a pop in the gas storage situation, it's important to maintain exposure to both oil and gas. . .for liquidity reasons.
It still allows us, therefore, to play the gas side (where the greater upside is likely to be), while providing an easy trading path in and out.
And you'll collect some decent income along the way.
AMJ comes with a 5.0% yield right now—the current coupon amount ($0.4825 as of April 24) annualized and divided by the closing price.
The Energy Advantage portfolio has recommended it since September 2010. As of now, we're up 19.8% on the share price alone, and that's not including the healthy dividends the stock receives on a quarterly basis.
Remember, MLPs pass along partnership dividends to unit holders. And the only genuine way to participate in that flow is to have access to the action on the interest coupons. AMJ shares give you such access. . .and some substantial profit potential, as well.
Of course, the AMJ is just one part of the larger approach to the markets in the year ahead. And it's been a staple of Kent's core holdings in the Energy Advantage portfolio, which he just restructured last week to ensure greater overall performance in the months ahead.
With greater production and more pipeline infrastructure being built in the months and years ahead, the midstream sector continues to provide significant opportunity in share appreciation and ever-increasing dividend payments to sweeten the deal.
Oil & Energy Investor
There's Always Money in Midstreams
Source: James Baldwin, Oil & Energy Investor (4/26/12)
"As long as you plant yourself in the middle of the supply chain, you're going to make some money."
It's a tricky market out there for energy investors.