The Energy Infrastructure Newsletter • Spring 2020
As an investment advisor, you have been subscribed to the Energy Infrastructure Newsletter so that you and your clients can stay abreast of this powerful emerging subsector. Formerly the MLP Newsletter, the Energy Infrastructure Newsletter is published in partnership with the Energy Infrastructure Council, a nonprofit trade association dedicated to advancing the interests of companies that develop and operate energy infrastructure. EIC addresses core public policy issues critical to investment in America’s energy infrastructure.
Midstream MLPs and Corporations:
A Defensive Investment in a Volatile Market
In this Q&A, Advisor Access and Stacey Morris, director of research with Alerian, delve into the value proposition offered by MLPs in an unsettled investment marketplace and uncertain times.
Advisor Access: Why should investors consider allocating to the MLP and energy infrastructure space?
Stacey Morris: Investors have historically been attracted to MLPs and energy infrastructure for generous income, real asset exposure, diversification and leverage to the growth in US energy production and exports. Oil price weakness is expected to dampen US production growth in the near term, which has pressured midstream equity prices and further depressed valuations.
However, with interest rates near historical lows, the energy infrastructure space continues to offer generous income, far exceeding other income-oriented sectors, such as REITs or utilities, with the added benefit of tax-advantaged income from MLPs. Additionally, midstream represents a more defensive means to gain energy exposure than oilfield services or exploration and production (E&P) companies in today’s volatile oil markets.
For those who have not looked at MLPs or energy infrastructure in some time, there have been many positive changes in recent years that have improved the positioning of the space for today’s challenging market environment, and in general.
AA: What does the sell-off in oil prices mean for midstream?
SM: Oil prices have fallen dramatically since mid-February, initially on demand concerns stemming from the impacts of COVID-19, and again, more recently, following the start of a Saudi-Russia price war. With oil prices down 58% between Feb. 21 and March 20, the Alerian Midstream Energy Index (AMNA) has fallen 51%.
Despite the fee-based nature of their businesses and relative defensiveness, midstream companies have not been spared from the oil and broader market turmoil, with MLPs disproportionately impacted by selling as a result of closed-end funds deleveraging. The sell-off in oil prices has raised concerns around the financial health of midstream’s customers, and depressed the near-term outlook for US energy production as producers respond to low oil prices by reducing activity and cutting growth spending. In response, midstream companies are cutting their growth and capital-spending plans.
At a high level, midstream providers can be protected by contract features like minimum volume commitments or take-or-pay agreements if volumes begin to decline, though company contracts vary. Gathering and processing (G&P) names have been particularly impacted, as these companies operate closest to the wellhead, and fewer new wells limit growth opportunities.
However, for midstream more broadly, underlying businesses likely have more stability than equity price moves suggest, with several names reiterating guidance since oil prices collapsed.
AA: What positives may the market be overlooking?
SM: Admittedly, there is much uncertainty facing the broader market and the future path of oil prices, but there are also several positives for energy infrastructure that would be easy to miss in today’s tough tape. For example, the midstream space has seen over $100 million in insider purchases from mid-February to mid-March, reflecting the confidence of management teams in the business model and long-term outlook. Multiple companies have reaffirmed 2020 EBITDA guidance in the wake of oil’s collapse, including ONEOK (OKE: NYSE), Energy Transfer Partners (ET: NYSE), and Enbridge (ENB: NYSE). ET also reiterated expectations to become free cash flow positive in 2021, after capital spending and distributions.
While a few names have cut their distributions, others have reaffirmed prior guidance, which highlights the defensiveness of their fee-based cash flows. Though it is difficult to look beyond the current challenges facing the energy space, midstream is expected to play a vital role in connecting US energy with global and domestic demand for years to come.
AA: How can investors get comfortable with these yields?
SM: With interest rates plunging and likely to remain low for some time, midstream’s yield profile is particularly attractive for income-seeking investors, but these investors want reassurance that energy infrastructure can deliver sustained income.
In many ways, midstream companies are financially healthier today than they have been in some time. For constituents of the Alerian MLP Infrastructure Index (AMZI), distribution coverage for Q4/19 averaged 1.5x, which implies a 50% cushion between cash being generated and cash paid as distributions. The improvement from an average of 1.2x for Q4/17 highlights just how far MLPs have come in efforts to improve their fundamental footing.
Additionally, 68.5% of the AMZI and 85.2% of the AMNA were investment-grade companies by weighting as of the end of February, underscoring the financial health of the space. While four G&P names have announced distribution/dividend cuts in recent days (MLPs: EnLink Midstream [ENLC: NYSE], EQM Midstream Partners [EQM: NYSE], DCP Midstream [DCP: NYSE]; C-Corp: Targa Resources [TRGP: NYSE]), other MLPs have reiterated 2020 distribution guidance (Holly Energy Partners [HEP: NYSE], Rattler Midstream [RTLR: NASDAQ.GS]). Enterprise Products Partners (EPD: NYSE) already announced its distribution for Q1/20, maintaining the payout from Q4/19.
Depending on the duration and severity of the downturn in oil prices, additional midstream companies may choose to cut their distributions to preserve their balance sheets, but across the board cuts are not anticipated, with larger names expected to be particularly resilient.
AA: How is midstream better positioned for today’s market headwinds?
SM: Over the last few years, the energy infrastructure space has been in a period of transition. Improvements have included a focus on reducing leverage, right-sizing distributions in some cases, moving toward self-funding equity growth capital and, for MLPs, eliminating incentive distribution rights. Additionally, several consolidation transactions occurred during this time that contributed to simpler structures.
While their operations are largely the same, midstream MLPs and corporations are very different today than they were five years ago—for the better. Companies are much less reliant on equity capital markets for funding their growth capital spending, and leverage metrics have improved for many names, though continued progress is needed. The stronger positioning of midstream will help the space navigate this challenging macro environment.
AA: Thank you, Stacey.
Stacey Morris is the Director of Research at Alerian, which equips investors to make informed decisions about energy infrastructure and master limited partnerships (MLPs). Ms. Morris engages with the investment community to increase awareness of the Alerian Index Series and support broader understanding of the role midstream assets play in North American energy markets. Ms. Morris was previously the investor relations manager for Alon USA Energy, overseeing investor communications for the corporation and its variable distribution MLP, Alon USA Partners. Prior to Alon, she covered the integrated majors and refiners at Raymond James as a senior associate in the firm’s Equity Research Division. Ms. Morris graduated summa cum laude with a Bachelor of Science in Business Administration from Stetson University, and is a CFA charter holder.