Are Pipelines a Dependable Route to Energy Independence?

Jay is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Ever since the discovery of oil and gas deposits in shale formations across the continental U.S., both energy supply and energy-related investment opportunities here in the U.S. have grown to become more promising. With many energy companies pushing on to build and bring new, domestic energy productions on line, energy investors may have also felt the urgency to hold a stake in the future of a potential American energy independence. An energy-independent U.S. would mean less imports from companies producing oil and gas overseas. To continue benefiting from the world’s largest energy market, investors of energy companies with mostly foreign productions may have to diversify their holdings and invest a fair share here in the U.S.

But investing in energy has never been a thing of certainty, considering that for every well that strikes, there are likely dry wells drilled somewhere else. Thus, an investor’s return really depends on how successful the invested company turns out to be in locating oil and gas deposits after racking up initial capital expenditures. Even with the apparently rich deposits of oil and gas in various shale formations in the U.S., not all companies that try to get in will find themselves in the very thick of it. But no matter who can bring the oil and gas up to the ground, someone else has to provide post-production logistics such as processing, storage and transportation.

Transporting energy products can be especially challenging, given that many existing energy trading delivery points and refinery facilities are not conveniently located or close to newly discovered oil and gas shales, many of which are to the north of the country. Many major energy destinations have been historically set up in southern parts of the country, most noticeably Cushing, Oklahoma, the settlement point for NYMEX’s WTI futures, and the greater Houston area and other Gulf of Mexico port locations, regions where the nation's refinery productions concentrate.

Having for years relied on imported energy, brought in by trans-ocean tankers to many of the nations southern ports, the U.S. has yet to build a well-connected domestic energy transportation infrastructure that can extend to many of the inland areas where the majority of the U.S. future energy supply will be produced. Since refinery facilities are mostly built in places with easy access to where oil tankers and other energy vessels unload, requirements for further domestic transportation have been minimal in the past and can be met by trucking and railroads on limited scales when necessary.

With the onslaught of domestic energy supply from production fields across the U.S. and likely places beyond the northern border in Canada, no ground transportation routes and inland waterways can seem to effectively move things to the mostly southern destinations. However, pipelines, an old means of transporting oil out of production fields and something that has been around since as early as when oil was first found and drilled for industrial uses in the U.S., can remain a viable alternative for domestic energy transportation.

Unlike the generally-perceived investment uncertainty involved in energy exploration and production, investing in energy pipelines can be less risky, benefiting from the indisputable, increasing needs of energy transportation for expanded domestic energy productions. However, before investors can lay a solid pipeline investment foundation, they should survey different investment grounds available to them. Companies, from specialized pipeline operators and refiners self-transporting their own energy supply to certain energy-focused investment funds, all offer access to investing in the energy-pipeline business.

Here are three companies to consider: Williams Cos. (NYSE: WMB), a major U.S. pipeline operator, Phillips 66 (NYSE: PSX), a refiner and Buffett’s favorite with assets in pipelines after the recent ConocoPhillips spin-off, and Kayne Anderson Midstream/Energy Fund (NYSE: KMF), a closed-end fund holding stakes mostly in pipeline companies.

Williams Cos. operates as a general partner for all its pipeline units that are set up as master-limited partnerships, or MLPs. Such business structures allow Williams Cos. to receive a higher percentage of growing cash earnings tax-free from its partnerships than what can be distributed to other limited partners. In turn, investors in Williams Cos. can expect increased dividend payouts over time.

An MLP as a business entity can be publicly traded with the issuance of so-called limited partnership units, as opposed to common shares for corporations. For example, Phillips 66 plans to hold an IPO and form an MLP with itself as a general partner for some of its current pipeline and logistics assets. Investors interested in the company’s pipeline business, but not necessarily its refinery operations, may consider to invest in only the company’s pipeline MLP as limited partners. Note that a general partner’s stake is not publicly traded. This way, investors can receive from the pipeline partnership’s cash earnings directly distributed to them without first losing a portion due to corporate tax. There would be the usual double taxation on their pipeline income, had they invested in Phillips 66, the parent company of the MLP.

Investors wishing to diversify their pipeline holdings may consider investing in pipeline-focused closed-end funds that all conveniently trade on a stock exchange. This helps eliminate the needs of having to pick and choose individual pipeline operators. For example, Kayne Anderson Midstream/Energy Fund holds shares in  both Williams Cos. and Kinder Morgan Inc., the largest U.S. pipeline company by market value. Another advantage of investing in a closed-end fund is that investors may benefit from leveraged returns as many closed-end funds borrow additional capital to amplify total returns beyond using only investors' contributions.

It’s estimated that it will take more than two decades to build all the pipelines needed for the new exploration and production currently taking place in the U.S. Energy-pipeline investors can reasonably expect to achieve stable returns for the foreseeable future. Moreover, in exchange for the favorable tax treatment for pipeline MLBs, all pipeline companies must return its free cash flows back to investors, making them particularly suitable for investors looking for steady income distributions.

 


JJtheArdent has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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