OBSERVATION: Energy companies are no longer being punished for increasing capital expenditures.
Let’s look at some reasons why:
1) These investments will create shareholder value, driving higher future cash flows and dividends. There is well-earned credibility that growth capital is being strategically invested to achieve attractive mid-teens returns, supporting volumetric growth in the Permian, increased exports, and rising power demand.
2) Free cash flow (cash flow after capital expenditures) is still available to grow dividends, buy back shares, and retire debt. Cash flow from operations is more than sufficient to cover capital expenditures and dividends to shareholders—this means companies do not have to issue additional equity or borrow to fund capital expenditures.
3) Large projects may have several joint venture partners which helps to lower capital requirements and reduce project risk. For example, the recently announced natural gas pipeline project, Blackcomb Pipeline—a joint venture with Whitewater, MPLX LP (NYSE: MPLX), Enbridge Inc. (NYSE: ENB), through the WPC joint venture, with Targa Resources Corp., (NYSE: TRGP)—will transport up to 2.5 billion cubic feet per day (Bcf/d) of natural gas from the Permian Basin in West Texas to the Agua Dulce area in South Texas.
4) The fears surrounding terminal values have dissipated. Investors are realizing the continued necessity of oil and gas infrastructure for decades to come, as exemplified by the extension of the useful life of natural gas power plants, nuclear facilities, and even some coal plants to meet growing electricity demand.
A key theme on Q2 earnings calls was rising capex budgets for midstream companies and the Street has taken note. Looking at estimates from one year ago versus current estimates, we see that the Wells Fargo Midstream Energy equity research team has increased its midstream cap ex forecast for the five-year period of 2023 to 2027 by about 21% from an annual average of ~$26 billion to ~$31 billion (albeit this is still well below the $49 billion in peak spending that occurred in 2019).
Wells Fargo Capex Adjustments Year over Year
Source: Company reports and Wells Fargo Securities, LLC estimates -
Wells Fargo Midstream Monthly Outlook: August 2024 published on 8/5/24
FREE CASH FLOW YIELD AS A VALUATION METRIC IS USEFUL, BUT NOT PERFECT
In recent years, free cash flow has become a popular valuation metric for energy investors, which may have arisen from a check on companies spending beyond their means as they chased growth. Exploration and production companies grew their production of oil and gas but generated suboptimal returns and destroyed shareholder value. Midstream energy companies also spent beyond their means and saw their financial leverage rise and stock price erode.
Money is fungible. It may be semantics, but if your cash flow from operations is insufficient to cover both your capital expenditures and dividends, you need to borrow money (or issue more equity) to fund those capital expenditures or pay the dividends. Regardless of how you spin it, the reality is that borrowing to fund capital projects or pay dividends still increases the company’s leverage. This is not a sustainable model.
Free cash flow is theoretically the highest amount you can pay out to shareholders. A company’s free cash flow yield, (free cash flow divided by stock price) is like a company’s dividend yield. The higher the free cash flow yield, the better for shareholders.
While free cash flow yield is a wonderful metric and a good tool for screening stocks, it’s not the be-all and end-all. Free cash flow may decrease for good reasons such as a company executing a program of high returning growth projects—companies should not be dissuaded from investing in respectable projects just because it will temporarily reduce its free cash flow. Investing capital is how companies grow, create value, and return more cash to shareholders. We believe financial discipline that leads to investments in high return projects should be the governor of free cash flow.
Relative to the S&P 500, midstream companies provide an attractive dividend yield of ~ 6% versus just 1.3% for the S&P 500 and growing free cash flow yields, as shown in the Wells Fargo chart below. In our view, midstream offers an attractive total return value proposition of ~6% yield plus ~5% expected dividend growth.
SAM’s Infrastructure Income Portfolio, with a diversified portfolio of midstream, utilities, and clean energy stocks, provides a current yield of ~ 4.5% with dividend growth potential of 5-7%.
We believe that a diversified portfolio provides lower risk with still attractive total return potential.
Midstream Free Cash Flow Yield
Source: FactSet and Wells Fargo Securities, LLC estimates
Wells Fargo Midstream Monthly Outlook: August 2024 published on 8/5/24
JULY REVIEW: UTILITIES LEAD ENERGY SECTOR GAINS
The rundown:
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 1.8% compared to 1.2% for the S&P 500 and 4.8% for its customized benchmark as of 7/31/24. The customized benchmark is more heavily weighted in utilities and clean energy, which both outperformed midstream in July. Year-to-date, SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 18.9% compared to 16.7% for the S&P 500 and 14.2% for its customized benchmark as of 7/31/24.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 1.9% versus 5.2% for its customized benchmark as of 7/31/24. Year-to-date, SAM’s Energy Transition Portfolio generated a return (net of fees) of 9.5% versus 5.6% for its customized benchmark as of 7/31/24.
Midstream was up in July with a total return of 3.8%, as measured by the Alerian Midstream Energy Index (AMNAX).
Utilities and the clean energy sector outperformed, generating a total return of 7.4% and 5.5%, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Global Clean Energy Index (SPGTCLTR), respectively.
Except for technology, all sectors in the S&P 500 reported a positive performance with real estate as the best performer. Energy delivered a 2.1% monthly total return. July month-end WTI crude oil and Henry Hub natural gas prices were $79.35 Bbl and $1.94 per MMBtu, down ~4% and ~20%, respectively from last month.
2024 Year-To-Date Total Return
Source: Bloomberg, NASDAQ and S&P Global
RESULTS: SINCE INCEPTION & ONE YEAR
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 94.3% and 18.3% for the periods since 11/10/20 inception and 1-year, respectively. This compares to a total return of 89.2% and 14.6%, respectively, for its customized benchmark and 64.9% and 22.1%, respectively, for the S&P 500 as of 7/31/24.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 10.4% and 0.6% for the periods since 4/29/21 inception and 1-year, respectively. This compares to a total return of 12.1% and 0.8%, respectively, for its customized benchmark and 37.9% and 22.1%, respectively, for the S&P 500 as of 7/31/24.
Sam Partners’ Infrastructure Income and Energy Transition Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality midstream energy companies, utilities and clean energy companies that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of ~4.5% and growth potential of ~5-7%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and aligns with favorable ESG ratings, offers investors a current yield of greater than 4%. In a world searching for yield, we believe these Strategies offer a compelling value proposition.
IMPORTANT DISCLOSURES
Siegel Asset Management Partners is a registered investment adviser located in Plainview, New York. The views expressed are those of Siegel Asset Management Partners and are not intended as investment advice or recommendation. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness, or reliability. All information is current as of the date of this material and is subject to change without notice. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, Siegel Asset Management Partners' returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
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