How These 4 Pipeline Stocks Make Money

Kinder Morgan (KMI +0.10%) has an attractive 3.9% yield as of this writing. Williams Companies‘ (WMB +0.22%) 3.2% yield is a bit lower, but Energy Transfer (ET -0.48%) and Enterprise Products Partners (EPD -0.73%) have dramatically higher yields at 7.1% and 6.1%, respectively. The average energy stock yields roughly 2.1%, but the yield isn’t the big story here. What’s really important is that these high-yielding investments operate in the midstream. Here’s why this single fact matters so much.

Energy has three sub-sectors

When most investors think about an energy stock, they probably envision an oil well spurting so-called black gold into the air with happy employees jumping around covered in the slick commodity. That’s the upstream, where commodities like oil and natural gas are produced. This is just the start of the process because neither of these fuels is particularly useful in its raw state.

Turning oil and natural gas into usable products occurs in the downstream. Essentially, chemical and refining companies process these raw commodities to produce fuels such as gasoline and the base materials used to make plastics, among other products. Both the upstream and the downstream are commodity-driven, so revenues and earnings can be highly volatile.

The midstream is entirely different. Businesses like Kinder Morgan, Williams, Energy Transfer, and Enterprise own energy infrastructure, such as pipelines, that connect the upstream to the downstream and to the rest of the world. They charge fees for moving these commodities, with the volume flowing through their systems being more important than the price of what is being moved.

Demand is always pretty strong for a pipeline business

What’s important to understand is that energy is vital to the normal functioning of the modern world. So demand for energy tends to remain strong regardless of oil prices, leading to fairly stable volumes for midstream businesses. That means that the fees Kinder Morgan, Williams, Energy Transfer, and Enterprise generate are highly consistent over time. That is what supports their attractive yields.

That said, there is a significant difference here regarding corporate structure. Kinder Morgan and Williams are both traditional corporations that pay taxes at the corporate level. That reduces the income they pass on to shareholders relative to master limited partnerships (MLPs) such as Energy Transfer and Enterprise.

An MLP is a pass-through entity, which leaves unitholders to deal with the tax consequences. However, these businesses also pass through tax benefits, such as depreciation, which means that some of the income is tax-advantaged. The end result is that there is a return-of-capital component that can delay taxation until you sell the MLP. Capital gains are typically taxed at a lower rate than dividend income, which is an additional benefit.

There’s a trade-off that you have to consider with MLPs, because they are much more complex to own. That will show up at tax time when you receive a K-1 statement, which you will need to use to fill out your taxes. You may need to consult a tax professional. And MLPs don’t play nicely with tax-advantaged retirement accounts, so you should think carefully before buying an MLP in an IRA, Roth IRA, or similar account. If you like to keep your life simple, a pipeline company structured as a traditional corporation, like Kinder Morgan or Williams, will probably be a better option.

The middle can be a very attractive location

There are nuances to every investment, but the big story with Kinder Morgan, Williams, Energy Transfer, and Enterprise Products Partners is that they tend to generate reliable cash flows to back up their attractive yields. They are not exciting businesses, but that’s the point. They are toll takers that let you focus on tracking your dividend payments while ignoring volatile commodity prices. For more conservative dividend investors who want some energy exposure, pipeline stocks are often a great fit.