How to Spread the Risk of Energy Investing for Income

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As the world continues to recover from the recession of 2008-09, those who depend on their investments for income have faced a challenge. Central banks in all of the major developed nations responded to the financial crisis and the resulting economic slowdown in a fairly conventional manner: they forced interest rates lower. The exact mechanics of how they did this varied somewhat, but for income investors the results were the same; a drastic pay cut.

As a result, many people have been forced to rethink their traditional bond holdings and turn to non-traditional ways of generating income. The energy markets offer several ways of achieving that.

Master Limited Partnerships (MLPs), utility stocks, and stock in large, mature, dividend paying companies all offer a chance for those in need of income to "juice" returns from a traditional bond portfolio. What many have lost sight of in this reach for yield, however, is that yield is essentially a reward for risk. Each of the above categories represents specific risks, so simply selling some bonds and buying into one of these instruments is not a smart move.

As with all things investing, diversification is paramount. An investment split between the following four suggestions would offer a combined yield of 4.275 percent -- not spectacular, but significantly better than the 2.5 percent currently available from U.S. government's 10-Year Notes, while spreading risk significantly.

MLP:  Master Limited Partnerships are "pass through" entities. That is to say that the majority of their profit is passed through to investors rather than retained. They must, by definition, receive around 90 percent of their income from real estate, natural resources and commodities. Oil and gas MLPs own the rights to extraction and production of wells and give income distributions from the cash flow that those assets generate.

For individual companies, there is a large tax benefit from operating in this way, as profit is not taxed - rather, the distributions alone are taxable. For investors, too, this is a benefit, as it avoids double taxation, but there is a catch. Distributions are treated separately to income and require additional filing. This can be avoided by investing in an MLP ETF such as the Alerian MLP Fund . For most regular income investors, the simplification and spread of risk that this offers is worth the additional fees paid to the fund manager, and the 5.9 percent yield that the fund offers is treated like a regular mutual fund dividend.

Utility: Local and regional power companies are a traditional source of regular income for more conservative investors, but recently, many such investors have found out that "defensive" stocks are not always safe. New Environmental Protection Agency regulations will require many companies to spend massive amounts to cut CO2 emissions over the next few years. In that environment, a utility company that has already done that, such as NextEra Energy , the holding company for Florida Power and Light, may offer the least risky way of generating utility income.

NextEra produces less than 5 percent of its energy from oil and coal, insulating it from the negative effects of the new regulations on cash flow and profits. This has resulted in significant support for the stock over the last few years, but even so, at current prices the stock offers a yield of over 3 percent.

Large Oil Companies:  Both BP and ExxonMobil have seen their stock fall quite drastically over the last few months. BP has dropped around 16.5 percent since the beginning of July and XOM, while not quite as bad, has still lost around 10 percent since the end of that month. Both disappointed with earnings last quarter and have suffered as the price of oil has fallen. BP also has some added disadvantages. They have a significant presence in Russia, which has weighed heavily along with lingering concerns about the costs associated with the Deepwater Horizon tragedy.

For holders of the stocks, this is bad news, and it may make a recommendation seem unlikely, but the drop in price has pushed yields up to where both offer a decent return as part of a risk diversified energy income strategy. BP is currently yielding 5.2 percent and Exxon 2.9 percent and neither looks expensive at forward price to earnings ratios (P/Es) of 9.43 and 12.19 respectively.

If you are struggling to generate income from traditional bond holdings, then, and want an alternative, combining these four investments is something to consider. There is still risk, of course as reward never comes without it, but spreading that risk between different types of investments makes the energy sector a slightly more attractive place to look for yield.

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