Looking for the Finest Texas Tea

07/09/2013 7:45 am EST

Focus: ENERGY

Roger Conrad

Founder and Chief Editor, Capitalist Times

These three oil plays represent some of the best values in the energy space right now, says Roger Conrad of Energy & Income Advisor.

Steven Halpern: We're here with income investing expert Roger Conrad, editor of the Energy & Income Advisor and the just-launched website Capitalist Times. How are you doing, Roger?

Roger Conrad: Great, Steve. How are you?

Steven Halpern: Very good. In recent weeks we've seen a jump-up in interest rates. Do you consider this a temporary move, or this is a start of a major trend toward even higher rates?

Roger Conrad: Well, if we're talking about what's considered the benchmark ten-year Treasury rate and the interest rates that sort of key off of that, like mortgage rates and so forth, I think we can probably look forward to higher interest rates going forward. I'm not sure how dramatic the rise will be.

I think you've got to get economic growth behind the rising interest rates for them to stick. We've seen, of course, over and over again in the last ten years really how interest rates have spiked up. And then growth has not been behind it, and then rates have come off again.

I mean that's definitely one part, but I do think those rates are very likely going to go higher. What the distinction is that people need to make, though, is how that effects corporate borrowing rates-because, of course, the corporate borrowing rates are what can take a big bite out of profits.

They've been a real big force for companies that do a lot of capital spending and so forth, so that's hugely important, and that's really the competition to the extent there is with dividend-paying stocks. At this point, what we have is a situation where companies have been pushing off their refinancing needs, and they can basically walk away when the market tightens up.

As long as we have this demand for bonds, particularly from institutions, I think you're going to have a seller's market for corporate bonds. In fact, right now we have bonds on Enterprise Products Partners (EPD) that come due in 2068 and they have a yield of maturity of just a little over 4%.

That's very, very low, and again it just tells us that corporate borrowing rates are very low. That's really the major thing to watch out for when we're talking about rising interest rates.

Steven Halpern: You mentioned an oil company. You recently referred to France's Total (TOT) as a bargain-priced super oil. Could you explain why that stock is so attractive?

Roger Conrad: Well, one thing that I think everybody needs to keep in mind with energy stocks is they go up and down with energy prices. But really what drives value over the long-term is going to be production growth: can a company increase its reserves, increase its production over time?

Now, if you look at super oils like Total, like Chevron (CVX) and Exxon (XOM) and others, it's very hard to maintain a rising production profile over time. The main reason is just simply because they're so big and they have reserves all over the world. They have such large production rates, and so it takes a lot of hard work and skillful exploration and so forth, good company management, to have a rising production profile.

While Total is one of those that does have a rising production profile-like Chevron, which is another that tends to do the same thing-the difference is that because it's domiciled in Europe, that's where its headquarters are, it trades as a discount to the super oils that trade in the United States. That's because of Europe's obvious problems that everybody's aware of, and that the perception that because Europe is struggling that the super oils are struggling as well.

That's definitely not true. You see that in the numbers. They're paid in US dollars because that's what oil's priced in. So a rising production profile, a discounted valuation because of Europe, and I think that produces a pretty big yield that is continuing to grow. I think those are good reasons to look at Total.

I'd say my favorite super oil is probably Chevron, but I think it's a little expensive right now. I think in this market, you're definitely punished for chasing stocks that have run up, as well as for selling stocks that may be temporarily out of favor.

That's the consequence of a market that's dominated by institutions-lots of trading, and lots of money sloshing around-so there's a lot of momentum, and if you follow it you're going to get burned. Total is an example of a really strong value in that energy space.

Steven Halpern: Great. You've long been considered one of the industry's leading experts on master limited partnerships. I know one you're particularly bullish on now is Kinder Morgan Energy Partners (KMP). Can you give a brief explanation why income investors should look at that?

Roger Conrad: Well, master limited partnerships have a few major attractions for people, one being that the dividend is paid partly return of capital, so you don't pay a tax on it until you sell; it comes off your cost basis. That's a tax advantage for investors, particularly with investment taxes going up this year.

But also, we're in the midst of a big American energy boom. That means that not only is there a lot more production going on, but also a lot of huge needs for what's called midstream energy, in facets such as pipelines, processing centers, gathering pipelines that take the gas and oil from various wells, and so forth.

All these things are basically fee-based businesses. What Kinder does is it goes out and builds these assets or buys them, and then signs the producers or shippers and marketers or whoever they are, the customers, into long-term contracts that are based on fees.

They've shut out the commodity price side of the equation, but they are benefiting as this American energy boom goes on and more and more infrastructure is needed.

Kinder yields right now around 6%. It's been one that's been undervalued, I think, by many investors, because there's been a lot of publicity about the general partner. And when you have a limited partner or general partner, the general partner does get the lion's share of the take.

Investors look at how much the take is relative to limited partners, and in Kinder's case it's larger than most, but you are compensated for that by a higher yield. And if you look at Kinder's peers, their yield is two percentage points less than Kinder, and Kinder is growing that dividend 6% to 7% a year.

That's a really good combination. It's a very low-risk combination, and it can also convey some tax advantages. This one was a lot cheaper a few weeks ago, but it's still pretty fairly priced in the mid-$80s.

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