Market Commentary: Looking for Yield in All the Wrong Places: Check Out Midstream Energy
A SAFE PORT IN THE STORM
An oft quoted adage is appropriate to describe this year’s stock market: “climbing the wall of worry.” The clock is ticking as we head toward an inevitable recession, according to most pundits. The debate is not about if it will happen, but rather when, and whether the landing will be hard or soft. What are investors to do? It would seem to us that owning defensive, yield oriented stocks should be part of the answer. Midstream energy fits the bill. Although many would correctly characterize the energy sector as cyclical because when the economy is strong, we consume more and vice a versa (when the economy is in a recession, we consume less). This is true. However, we believe that the midstream energy sub-sector can prove resilient and defensive, even during a recession.
WHY OWN MIDSTREAM STOCKS?
Potential to re-rate higher. Midstream deserves a utility-like valuation because of similar cash flow and risk profiles (in our opinion). Utilities are considered defensive investments because they are monopolies, and electricity demand is relatively inelastic. They trade at higher multiples of earnings and cash flow and trade at lower yields than midstream companies, as they are considered safer investments with lower risk profiles. However, utilities’ earnings typically have some weather sensitivity, and periodically, utilities are required to file rate cases that creates regulatory risks. Below, we suggest that midstream companies generate stable cash flows and that their risk profile has greatly improved. We think the valuation disparity is no longer justified.
Midstream Valuation Gap Versus Utilities
Source: Wells Fargo Midstream Monthly Outlook: April 2023
Midstream energy companies link energy supplies and markets. Their services are essential to energy consumption and their vast infrastructure, e.g., pipelines, processing facilities, storage, and terminals are almost impossible to replicate (especially given difficulties in obtaining timely permits). Yet, this part of the energy value chain seems under-appreciated, although one can argue that in general, the energy sector is under-appreciated.
Midstream companies have relatively low business risk and operate near monopolies in many of their jurisdictions. The past issue for midstream was a bad financial model (hindsight is 20/20) not a bad business model, in our view. Companies relied too heavily on the capital markets to fund a period of unprecedented capital expansion. This was exacerbated by the collapse in commodity prices, which caused some producer customers to go bankrupt. Subsequently, the energy sector has found financial discipline and is no longer overly reliant on capital markets (other than perhaps to refinance debt). Producer customer balance sheets have never been stronger with very little leverage. (Counter-party risk is no longer a major concern, but not to be ignored). Should we experience a recession, midstream companies’ strong balance sheets, high cash flow coverage of dividends (i.e., lower payout ratios), and excess cash after paying dividends and capital expenditures provide a margin of safety.
Secure and growing dividends. The midstream sector currently yields approximately 6% (although some quality companies yield around 10%) and is expected to grow dividends by about 5%.
Midstream is a low-risk way to participate in the energy transition. We recently hosted a fireside chat discussing the future of natural gas and its role in the energy transition with Chad Zamarin, EVP of Corporate Strategic Development of Williams (NYSE-WMB). We believe that Williams, a premier natural gas infrastructure company epitomizes the role that traditional energy companies can play in the energy transition.
Two Main Takeaways from Our Chat:
Natural gas is a vital fuel in meeting decarbonization goals and will be consumed globally for decades to come. The U.S. has an abundant and reliable supply of relatively cheap natural gas that can be exported to meet global needs. In its 2023 Annual Energy Outlook, the EIA reference [base] case projects U.S. production growth to support a more than doubling of exports through 2050.
Traditional energy companies have the skill set essential to build and operate critical clean energy infrastructure. These companies will be important participants if net zero ambitions are to be met.
Liquefied Natural Gas Exports Drive Production; Domestic Consumption Remains Stable
Source: U.S. Energy Information Administration (EIA), Annual Energy Outlook 2023 (AEO2023) Note: Shaded regions represent maximum and minimum values for each projection year across the AEO2023 reference case and side cases. ZTC=Zero-Carbon Technology Cost
Natural gas displacement of coal in power generation is the number one reason that the U.S. has led the world in reducing carbon emissions.
C02 Emissions Reductions Relative To 2005 Caused by Changes in the Fuels Mix of Electricity Generation
Source: U.S. Energy Information Administration (EIA), Monthly Energy Review, October 2022
Natural gas is needed as a backup fuel for wind and solar generation, which are intermittent sources of power. The wind doesn’t always blow, and the sun doesn’t always shine. Battery storage can only provide power for up to four hours.
Hydrogen should be viewed as an incremental source of energy but is unlikely to make natural gas obsolete.
Natural gas pipelines can be used to transport hydrogen. Blending just 10% of hydrogen in Williams’ Northwest Pipeline is more hydrogen than produced in the world today.
Williams’ Strategic Focus In 2021, Williams created New Energy Ventures to invest in clean energy. It is guided by the following four principles:
Reduce emissions for itself, customers, and partners
Earn appropriate returns on investment
Leverage its competitive advantages and core competencies
Invest in scalable businesses
New Energy Ventures is exploring opportunities in the following:
Carbon capture utilization and sequestration (CCUS)
RNG: renewable natural gas
Solar to electrify its pipelines
Next Gen Gas defined by Williams as “natural gas that has been independently certified as low emissions across all segments of the value chain”
Hydrogen and CCUS have garnered a lot of attention and investment dollars industrywide. Williams is participating in 6 hydrogen hubs that could potentially receive DOE subsidies. The DOE has allocated about $8 billion dollars to support demonstration projects involving networks of clean hydrogen producers and consumers and the connecting infrastructure.
The Inflation Reduction Act (IRA) tax subsidies (45 Q) make carbon capture sequestration a viable investment. Williams’ Louisiana Energy Gateway project will transport about 1.8 bcf/d of natural gas from the Haynesville to Gulf Coast markets and capture, transport and sequester a minimum of 2 million tons per year of CO2.
Williams expects to invest about $100 million in clean energy projects this year and $100 to $200 million in future years.
MARCH REVIEW: ENERGY HOLDS STEADY AMIDST FINANCIAL SECTOR WOES
The stock market has proven resilient despite the bank crisis that emerged in March and ongoing economic concerns:
Crude oil and natural gas prices were soft and volatile, hitting 52-week lows.
Crude futures dipped as low as $66.74/bbl and natural gas spent a day below $2.00/MMBtu.
Four sectors in the S&P 500 reported a negative performance, ranging from a -0.2% monthly total return for Energy and about -10% for Financials.
SAM’s results reflect an overweight position in traditional energy:
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 0.4% compared to 3.7% for the S&P 500 and 1.6% for its customized benchmark.
SAM’s Energy Transition Portfolio generated a return (net) of 0.5% vs. 2.1% for its customized benchmark.
Utilities and Clean Energy were the strongest performers with a total return of 5.4% (as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and 2.7%, respectively [the S&P Clean Energy Index (SPGTCLTR)].
The midstream sector generated a total return of -0.1%, as measured by the Alerian Midstream Energy Index (AMNAX).
Source: Bloomberg, S&P Global and NASDAQ Note: Total returns as of 4/14/23.
RESULTS: YEAR-TO-DATE & SINCE INCEPTION
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -0.6% and 54.9% for the 1-year and since 11/10/20 inception periods, respectively. This compares to a total return of -3.5% and 51.7%, respectively, for its customized benchmark and -7.7% and 19.8%, respectively, for the S&P 500.
SAM’s Energy Transition Portfolio generated a return (net of fees) of -7.5% and 10.5% for the 1-year and since 4/29/21 inception periods, respectively. This compares to a total return of -5.0% and 5.2%, respectively, for its customized benchmark and -7.7% and 0.6%, respectively, for the S&P 500.
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 clean energy companies, midstream energy companies and utilities 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 ~5% and growth potential of ~5-6%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of ~4%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.