Stocks And Commodities: Strange Bedfellows

Includes: CMLP, EPB, KMP
by: Dr. Stephen Leeb

Last week we spoke about two areas that can be thought of as proverbial “strange bedfellows” when it comes to investments that are likely to outperform for the next 12-18 months, and possibly even longer:

The first is commodities, while the second is stocks that produce solid and preferably growing income streams.

Obviously, historically we would not expect commodities and income to go together. Typically, when commodities rise, so do interest rates - and stocks related to higher interest rates tend to go down, just as bonds go down when inflation goes up. Indeed, during the 1970s, the last period of rising commodity prices bonds, were the worst possible investment you could own, as were income stocks.

This time around, it’s quite a different story. As we learned graphically in 2008, and the Fed seems to have gotten the message (the Europeans seem a little slow to get it, but eventually they’ll catch on), unlike in the ‘70s, high commodity prices today, while still inflationary, also serve as what can be termed a massive deflationary tax on the economy.

Today as we look at our oil quotes, we notice that the average of Brent and WTI is over $100. This means that at least in parts of the country gasoline will be close to $4 a gallon, and for high octane, over $4. These are killer prices, as are the costs for utilities. The statistic we used last week is perhaps the most graphic example: The bottom quintile of our population is currently paying 55 percent of their income just for the essentials of food and energy.

Without loose monetary policy, without massive money for growth to overcome these deflationary forces, it seems clear that what’s true now for the bottom 20 percent will soon be true for the bottom 40 percent...and who knows how far it will extend after that?

This is a dangerous situation, and one that requires the Fed to keep interest rates exceptionally low.

So if you’re buying a 10-year bond today, you have to be content with a 2 percent yield.

And just in case you’re wondering…even in the year 2011, when Europe has come close to imploding and the U.S. has done nothing more than crawl along as it struggles with conditions that in the past would have led to a massive drop in commodity prices (as it did in the ‘90s), many commodity indices are still showing green, and virtually every commodity index is outperforming the stock market. Moreover, the average price for commodities for the entire year will be at a record high!

Now imagine what happens if Europe ever gets its act together and unemployment in the U.S. falls to 7.5 percent. It will take massive increases in wages even for those well above the bottom 20 percent just to afford what could then be $6 or $7 per gallon gasoline.

We would also see copper at prices that Wall Street can’t even calculate at present as it’s just too difficult to determine the number that would match supply and demand.

The case for commodities is clear, but so is the case for income. For it turns out the only way to battle the extraordinary form of virtual ‘taxation’ that high and rising prices for commodities impose on us (as I’ve put it before), is to keep interest rates very low. And what better way to kill two birds with one stone, especially if you are interested in income, than to invest in those kinds of income plays that are leveraged to commodities and can benefit from their greater usage -- and therefore the higher prices they will command.

Here we’re talking about Master Limited Partnerships in the energy industry.

These are companies which by law are required to distribute the bulk of their cash flow to stockholders. This automatically assures high income. In many cases, as commodity prices rise, it also assures growing income, as well.

There’s an aspect to MLPs that is both good and bad, though, and it involves taxes.

The bad is that the tax regulations regarding MLPs are so complicated when you invest in them you will probably require assistance in filing out your tax returns. The good aspect is twofold. While you’re dealing with those tax complications at the end of the year, you’ll also be counting up your profits. What’s more, it’s precisely because of those tax complications that many people don’t go near these investment vehicles (especially investment professionals in the institutional space). As a result, these stocks are to some extent artificially cheap, as a massive universe of buyers shuns them – not because of high risk or the absence of growth or income, but because of the tax complications, which is perceived as a deal breaker.

But in a world like this, if you’re getting income streams from the good, solid MLPs that sometimes reach 10 percent, and total returns that easily exceed 10 percent, the tax complications are well worth it.

As for the particular MLPs we recommend, they are, again, in the energy area – and poised to capitalize on high oil prices. Here are three of our favorites – and you can expect us to come back to this theme, because they’re so good.

The first is what has to be acknowledged as the king of the energy-related MLPs: Kinder Morgan Energy Partners L.P. (NYSE:KMP). It owns 37,000 miles of pipelines, nearly 200 terminals, and moves massive amounts of virtually all energy products, from carbon dioxide (which is used to revitalize old oil wells) to oil and natural gas.

The company has a remarkable record, in that for at least the past 15 years distributions have been raised. By investing, you are pocketing a 6 percent yield and very likely can look forward to distributions that increase 5-10 percent a year. At the low end, this means total returns of 11 percent, whereas the upside could deliver total returns of 16 percent.

El Paso Pipeline Partners L.P. (NYSE:EPB) is a company that began trading at the end of 2007. Its first distribution in 2008 was $1.01 a unit; expected distribution in 2011 is $1.87 per unit, and projected for 2012 is $2.10 per unit. The current yield of 6 percent is not only attractive in itself, but becomes extraordinarily attractive when one considers that distributions should easily grow at a 9 percent or greater clip over the next five years.

One thing to note here is that Kinder Morgan’s parent company Kinder Morgan, Inc. (KMI) recently took over EPB’s parent company El Paso Corp. (EP). EPB dropped on the news. The reason is that EPB had largely grown in recent years by purchasing assets from EP. Therefore, the transaction means that KMI may decide to sell pipelines to KMP which might otherwise have gone to EPB. This means that EPB could lose some growth to KMP. However, if that should happen, it means Kinder Morgan’s growth will be greater than before. So the best strategy here is to own both Kinder Morgan and El Paso, or at least, don’t buy El Paso without buying Kinder Morgan.

Finally, our third choice among these energy MLPs is the more speculative Inergy L.P. (NRGY), a company that has a much larger retail presence than our two other picks, though it also deals on the wholesale level. The primary products it distributes, in many cases to residential customers, are propane and other natural gas liquids. It has put in place plans for growth that we have no problem signing off on.

What attracts us to this company is that its most recent quarter was a big disappointment, which led to a sharp fall in the stock’s price. Our analysis tells us that this was a one-time event that will not affect the company’s longer-term growth strategies.

Indeed, a close study of the company’s record suggests that we’re correct. Since 2001, when it began trading, it has raised its distribution every year at a compounded annualized rate of more than 10 percent. While we doubt that 10 percent is a reasonable number going forward, a 5 percent growth in distribution is certainly not out of the question. Given that the stock right now yields a whopping 12 percent, we’re talking a strong possibility of annualized gains of about 17 percent. That should be some comfort when it comes to paying higher heating bills, especially if you’re using propane to do so, as many more people are doing today (which incidentally is another good argument for the stock).

Similarly, owning Kinder Morgan and other oil-related MLPs will provide consolation when you’re paying those high prices for gasoline at the pump, knowing that those same high gas prices are partly responsible for the nice income you’ll be taking home from these excellent energy-leveraged investments.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.