Three Secrets to Earning Double-Digit Yields From Oil

Monday, December 21, 2009 - 5:34pm

by Tom Hutchinson

Future historians may well define our current time on Earth as the "oil age."

It is estimated that the world consumes 80-85 million barrels of oil per day. And as industrialization expands across the globe on an unprecedented scale, long-term demand is on the rise.

However, the financial crisis and worldwide recession caused oil prices to plummet from a high of about $147 per barrel last summer all the way to $34 a barrel.

But, things are changing. As panic from the financial crisis has ebbed, crude oil prices have already begun to rise, more than doubling to $73 a barrel today. In fact, Goldman Sachs revised oil price forecasts to $95 by the end of 2010.
 
But if you're an income investor, how can you turn black gold into high income? You can't do it with the major oil companies. ExxonMobil (NYSE: XOM) is only yielding about 2.4% and Chevron (NYSE: CVX) only yields about 3.5%. Instead, you need to expand your options...

I've found three areas investors can use to supercharge their income by earning double-digit yields -- all powered by black gold.

Oil Income Play #1: Canadian Trusts -- Yields of 10% or More
Our first stop for income from oil is a land where the yields are ripe, luscious and double-digit -- and it's just north of the border. Canadian royalty trusts are oil and gas producers that typically pay sky-high distributions. They are able to pay high yields because they don't have to pay corporate income taxes if they distribute the bulk of their income to unitholders. Many of these trusts are currently paying as high as 10% to 14%.

Even though they are found in Canada, it's easy as pie for stateside investors to buy Canadian trusts. Many trade right on the NYSE. You can buy them just as easily as buying a common stock.

The distributions from the trusts typically qualify for the 15% maximum tax rate. While there is a 15% Canadian withholding tax, you can claim this as a foreign tax credit. In addition, distributions are usually paid in Canadian dollars. If the U.S. dollar falls against the Canadian dollar (which it has by more than -10% since March), your distributions rise when converted into U.S. dollars -- boosting your income without the trust even raising its payment.

Oil Income Play #2: Master Limited Partnerships -- Steadily Rising Income
If you want to trade in a few points of income for steadily rising payments, then master limited partnerships (MLP Kinder Morgan (NYSE: KMP) paid just $0.475 per share each quarter in 2001... but now pays $1.05 every quarter.

Most MLPs are in the energy arena. A majority make their money by owning oil and gas pipelines and processing facilities. They essentially act as toll roads -- receiving a fee based on the amount of volume shipped via their network.

MLPs allow for "pass-through" income. This means that they're not subject to corporate income taxes. The result is that more cash is available for distributions than would be available if the company had incorporated.

Most MLP distributions are comprised of about 20% net income and 80% return of capital (which is really just an allowance for depletion or depreciation). The income portion is generally taxed at your ordinary income tax rate. Return of capital distributions lead to a reduction in your cost basis, meaning you don't pay taxes on the return of capital portion until you sell the security, making MLPs ideal for long-term investors.

There is one glitch with MLPs. Individual MLPs aren't suitable for individual retirement or other tax-deferred accounts because they generate a type of income called "unrelated business taxable income" (UTBI). If your retirement account earns more than $1,000 of this income, then you'll end up paying taxes on it. As a result, you probably want to hold MLPs in a regular brokerage account.

Oil Income Play #3: Closed-End Funds -- Professional Management

If you're looking to earn high yields from oil and enjoy professional management, then my third find is the perfect match.

With closed-end funds focused on oil and energy, you'll own a share of a vast portfolio of stocks that would be nearly impossible to select and amass yourself. Also, funds have the resources and expertise to search every corner of the globe for the best opportunities.

It's no surprise then that I've found more than 20 funds focused on the energy sector yielding more than 6%.

Taxation of funds will vary from fund to fund, depending on where its income is sourced. But in some cases funds they can actually make taxes easier. For instance, the Kayne Anderson Energy Total Return Fund (NYSE: KYE) invests in a basket of master limited partnerships. The fund takes care of the UTBI problem mentioned above -- and actually makes tax time smoother for investors.

P.S. Just two years ago my boss Paul Tracy started an unusual investing program. It loads his portfolio with special MLPs, closed-end funds, and several other safe and powerful income securities paying high, double-digit yields.

This program is already paying him more than $2,700 a month. What's more, his monthly payments are growing and will soon top $100 per day or $3,000 per month. He swears by this strategy... and he's confident you can transform your own portfolio into a daily income machine, just like he has. Here's all you have to do...

Tom Hutchinson does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.