We recently got back on the road again and visited midstream companies in Dallas, Houston, and Tulsa. Everyone was in a jovial mood. High oil and natural gas prices can do that for energy guys.
Here are some of our takeaways:
• Keep the pipes full. Managements are focused on keeping their infrastructure fully utilized
after contracts roll over because of excess industry capacity built during the past capex super cycle. Energy Transfer’s (NYSE: ET) proposed acquisition of Enable Midstream (NYSE: ENBL) is being pursued in part to attract more volume onto to its pipeline system. However, M&A has yet to become popular among midstream companies. Midstream companies also continue to evaluate opportunities to repurpose pipelines for different services, such as transporting natural gas liquids (NGLs) instead of crude oil. Another strategy is to combine assets into a joint venture, which could enable efficiencies and cost synergies. An example of this is the agreement between Plains All American (NYSE: PAA & PAGP) and Oryx Midstream Holdings LLC to combine their Permian assets.
• The super capex cycle is over. An unprecedented amount of capital was deployed over the last decade to support the shale revolution. According to Wells Fargo Research, capital expenditures are expected to fall from a peak of $49 billion in 2019 (for the companies it tracks) to $20 billion in 2022. Billions of dollars were spent to construct pipelines, processing plants, fractionation facilities, and export docks.
• M&A is not top of mind. While the popular opinion over the years has been that the midstream sector needs to consolidate, the companies we visited didn’t seem to be actively engaged in pursuing combinations. The persistent obstacles remain social issues, anti-trust concerns and asset mix of potential targets. It’s difficult to justify acquiring a company that has disparate assets of which only a few are deemed attractive. It is interesting to note however, that investment bankers were also making the rounds visiting companies.
• Discipline on the E&P front. Drilling activity has increased primarily by private companies, most notably in the Permian Basin. The debate is whether public E&P companies will maintain their discipline or return to the days of “drill baby drill.” The consensus amongst the companies we visited seems to be that oil and gas prices will likely continue to move higher and activity will increase in a disciplined manner among public companies — they account for ~75% of oil and gas production. Private companies have different incentives to grow and are more likely to outspend their cash flow. • Cost creep doesn’t appear to be an issue. Contract labor costs have risen, but not materially, while the increase in steel costs have moderated. Most companies are insulated from inflation with cost escalators built into their contracts.
• ESG in focus. Management teams are acutely sensitive to environmental, social, and governance (ESG) issues. They are proactively targeting ways to reduce emissions and seek clean energy investments that meet their return on capital hurdle rates.
Unequivocally, they are taking ESG seriously.
• Debt reduction with free cash flow. Companies in the midstream sector are financially healthy, with debt metrics within targeted ranges and dividends well covered by cash flow. In fact, companies are generating free cash flow after capital expenditures and paying dividends. Unsurprisingly, top priority remains to continue reducing debt and maintaining a strong balance sheet. The debate is between dividend increases and/or stock buybacks.
Spoiler alert, we’re not a fan of special dividends.
• A case for stock buybacks. Dividend increases are tough to justify given high current yields — managements contend that their company’s stock is not being valued based on its dividend and growth prospects, while investors would seem to favor stock buybacks over dividend increases. The returns from a stock buyback are immediate, as a company saves on the dividend it otherwise would pay. The average yield is ~7% and higher than the cost of debt. In addition, stocks are still cheap and represent good value; stock buybacks at current prices are a good investment.
IN OUR VIEW: PUT SOME ENERGY IN YOUR PORTFOLIO
We believe investors should allocate a portion of their portfolio to the energy sector for several reasons:
1. The energy sector has reached an inflection point.
Energy companies are adhering to the demands of investors. The message to be responsible stewards, both financially and environmentally, has resonated. Companies have abandoned growth for the sake of growth and are focused on generating adequate returns on investment and returning cash to shareholders via dividends and/or stock buybacks. This means living within free cash flow. There is no turning back.
As it pertains to the environment, companies have begun to set aggressive emissions reduction targets. Additionally, midstream companies are well positioned to provide the requisite infrastructure in the energy transition to a net zero carbon world. It’s the right thing to do and it’s good for business.
2. Midstream stocks represent good value.
According to Wells Fargo Research, the midstream stocks they track still trade below their five and ten-year average cash flow multiples. This compares to broader market indices such as the S&P 500, that trade at high historic valuation multiples (i.e., a P/E multiple of ~23x versus a 5-year average of ~18x).
3. High current yields in the midstream sector compare very favorably to projected stock market returns of 6 to 8% next year.
The Alerian Midstream Energy Index yields about 6.5%. This combined with just modest growth should deliver a very attractive total return.
4. Free cash flow supports dividend growth.
Skeptics may argue that high dividend yields suggest potential for dividend cuts.
The pessimism is understandable given the sector’s recent history of dividend resets. However, that’s looking in the rearview mirror. The energy sector and midstream specifically are well positioned to generate significant free cash flow that will support dividends and growth, in our view.
5. Benefits of diversification.
The market is fickle and investment styles go in and out of favor. Modern portfolio theory suggests that an optimal risk adjusted return can be achieved through diversification.
Put some energy into your portfolio!
6. It often pays to be a contrarian. The midstream sector remains unpopular among investors. Funds continue to be withdrawn from midstream ETFs and ETNs — albeit at a slower rate — despite the sector’s capital appreciation year-to date. The appreciation in stocks can most likely be attributed to computer-driven purchases based on algorithms, rather than retail or institutional demand. We find it somewhat surprising that the midstream sector continues to experience fund outflows, while the energy sector more broadly has had robust inflows. According to Bloomberg, almost $18 billion has been invested through the first half of 2021 in U.S. energy ETFs, exceeding any from the previous ten years.
[Source: Bloomberg]
The Beat Goes On: Energy Continues to Outperform
Energy appreciated 4.5% in June, the best performing sector in the S&P 500 by a wide margin in the first half of the year, posting a gain of 42.4% versus 14.4% for the S&P 500. However, the sector is still down 10.8% from year-end 2019, the worst in the index. Financials were the next best performer in the first half of 2021 at 24.5%. The utilities sector has been the worst performer, albeit still managing a positive price appreciation of 0.79%, even after a loss of 2.4% in June.
Higher oil and natural gas prices have propelled energy stocks higher. The story remains the same—energy demand has recovered with the reopening of the global economy while supply has been restrained because OPEC Plus and shale producers have maintained their discipline. Oil (WTI) closed the first half at $73.50 per barrel, up from $66.63 at the end of May, and $47.47 at the start of the year. The last time oil prices reached this level was October 2018.
Natural gas prices (Henry Hub) ended June at $3.79 per MMBtu, up ~30% for the month and ~61% year-to-date. For June, natural gas prices averaged $3.26, the highest for June since 2014. Prices were pushed higher by a combination of increased consumption in the electric power sector due to warmer weather across the U.S. and increased liquefied natural gas (LNG) exports.
The 10-year treasury yield was 1.47% at the end of June versus 1.58% at the end of May and 0.92% at the start of the year. Surprisingly, yields have moved even lower throughout July, despite inflation concerns.
We Believe a Diversified Approach to Investments in Midstream, Utilities, And Renewables Will Deliver the Best Risk Adjusted Returns SAM Partners’ Infrastructure Portfolio had another good month in June with a 2.1% total return, just slightly below the S&P 500’s return of 2.3%. Our H1’21 total return of 25.5% compares very favorably with the 15.2% return for the S&P 500. Leading the way in the first half of the year has been our heavy allocation to Midstream, which produced total returns of 4.0% and 41.0% for June and H1’21, respectively, versus 3.2% and 40.6% for the Alerian Midstream Energy Index (AMNA). Our YieldCo holdings rebounded from a loss in May (-5.5%) to generate a positive return of 4.7% in June (versus 2.9% for the S&P Global Clean Energy Index (SPGTCED)). Year-to-date, our YieldCo holdings produced a total return of 10.0% versus a loss of 15.9% for clean energy stocks. Utilities continue to weigh down our returns with a total return loss of -3.6% for June, but a respectable gain of 5.5% for the first half of 2021. This compares with returns of -2.3% and 3.8%, respectively, for the PHLX Utilities Index.
A WORD ON COMMODITIES
Crude Oil — OPEC Plus Steps into a Pothole
At the start of July, the OPEC, non-OPEC Ministerial Meeting was called off because of a stalemate between Saudi Arabia and the United Arab Emirates (UAE). The “Declaration of Cooperation” (DOC) agreed to by OPEC Plus in December 2020 worked remarkably well up until now. It called for monthly meetings starting in January 2021 through April 2022 to flexibly increase oil production based on market conditions. Most participants tentatively agreed to raise production by 400,000 barrels per day in August—however, the UAE wanted a higher baseline to determine its share of production cuts and was against extending the DOC to the end of 2022. As a result, the gradual return of the remaining 5.8 million barrels per day of production cuts to the market has stalled at July levels.
We maintain that the greater risk to oil prices is to the upside, with OECD inventories now below historical averages and global demand increasing. The risk to the downside is the potential for the delta COVID variant to derail the global demand recovery and the unraveling of OPEC Plus to flood the market with oil. Either way, it may mean more volatile prices in the near term.
Natural Gas — Part of the Solution
[Source: U.S. Energy Information Administration, Power Plant Operations Report]
The primary reason that CO2 emissions from the electric power sector in the U.S. has declined from 2,544 (MMmt) in 2005 to 1,724 in 2019 was the shift from coal to natural gas and secondarily from the increase in renewables. We seem to take natural gas for granted, but we shouldn’t. It’s abundant, affordable, reliable, and cleaner burning than coal. While some have clamored for using less natural gas, coal consumption globally is increasing, most notably in Asia. Renewables can’t pick up the slack on their own. We doubt that the indigent people without any electricity would be opposed to burning coal.
I’m just saying…
SAM Partners’ Infrastructure Income Strategy seeks 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 renewable energy companies. In a world starved for yield, we believe these stocks offer a compelling value proposition. Our Infrastructure Income Strategy offers investors a current yield of ~6% (as of 6/30/21) and growth potential of 3% to 4%. The midstream portion of the portfolio has a sustainable yield of ~7% while utilities and renewables provide yields of 3% and 4%, respectively.
