Uncertainty in High-Yield Sector Creates 22% Income Opportunity
Oil and gas pipeline companies have grabbed investors’ attention this summer as a number of mergers have occurred in the industry. At the top of the list is a $71 billion dollar consolidation led by Kinder Morgan (NYSE: KMI).
A surge in oil and natural gas production in the United States has led to high demand for pipelines and fuel storage capacity. This increase in production is largely due to the proliferation of “fracking,” in which sand, water and other chemicals are pumped at high pressure into rock formations. The pressure fractures the formations releasing trapped gas and oil.
Most pipeline companies are organized as master limited partnerships (MLPs). These business structures have some key advantages such as the ability to avoid corporate taxes. However, they are also required to pay out the majority of their operating profits to shareholders in the form of distributions, leaving little capital available for expansion or business development.
With strong demand and incentive for these companies to expand, the environment has been ripe for mergers and acquisitions. In some cases these transactions have included transitions away from the MLP structure, and in others the combined company has been left with greater resources to drive more profits.
Because of the large number of mergers, investors have begun looking at oil and gas pipeline companies to determine which might make for good takeover targets. The speculation has led to elevated option premiums as uncertainty is high. Higher option premiums work to our favor as income traders, allowing us to generate more cash from our investment accounts.
Today, I want to set up a covered call trade for Enbridge Energy Partners (NYSE: EEP), a master limited partnership that is moving higher along with the entire MLP group.
To enter this trade, we’re going to buy EEP in 100-share lots using a limit price of $37.10 to ensure that we receive a fair price. Once we have purchased shares, we can then sell one EEP Oct 37.50 Call for every 100 shares using a limit of $0.45 per share ($45 per contract).
By selling theses call options, we are agreeing to sell our shares of EEP at the $37.50 strike price, provided the stock closes above this level when the options expire on Oct. 18. Since we are buying the shares at $37.10 or less, we can expect to make at least $0.40 per share if this sale takes place. At the same time, we will get to keep the $0.45 per share in option premium we received when selling the call contracts, so our net profit will be at least $0.85 per share.
Our net cost for the trade will be the $37.10 limit price for the stock minus the $0.45 options premium, or $36.65, and it is possible you will receive a better price when entering the trade. This is also our breakeven, which means EEP could trade down to $36.65 and we still would not have a loss on the trade.
If shares move above our strike price and get called away, the expected profit of $0.85 represents a 2.3% gain over our net cost of $36.65. Since the trade will only be open for 38 days, our per-year rate of return is 22%.
While the bullish trend for EEP leads me to believe that we have a high probability of the stock closing above $37.50 when the October calls expire, there is also an advantage for us if EEP remains below this level.
EEP pays out a lucrative $0.555 quarterly dividend, for a current yield of 6%, and that dividend has been increasing steadily over the past few years. The next scheduled dividend payment is in early November, with the stock going ex-dividend on Nov. 5.
So if EEP does not trade above $37.50 before our calls expire, we will keep the shares and be eligible to receive the company’s quarterly dividend. From that point, we could sell additional covered calls against our position, generating more income.
Note: Selling covered calls is one of the easiest ways to generate consistent income in the market. In fact, our resident options income expert, Amber Hestla, recently compared it to collecting rent on an investment property you own. Click here to learn how you can collect $1,200 or more each month from the stocks in your portfolio.