Market Commentary: The Midstream Energy Sector; A Value Play in Energy Transition
In Our View: The Midstream Energy Sector Can Re-Rate Higher
The midstream energy sector has the potential to re-rate higher if investors recognize that the sector is part of the energy transition to a decarbonized future. Key reasons include:
• Fossil fuels are not going away. As we’ve written before, we believe fossil fuels are not going away and concerns about terminal value are misplaced. Please see our essay, “A World Without Fossil Fuels” for details.
• They are well-positioned to provide the requisite infrastructure in a net zero carbon world. For example, today’s pipeline infrastructure may be utilized to transport renewable diesel – and eventually – repurposed to transport hydrogen. In fact, Williams Cos. (NYSE – WMB) filed a FERC application in March for a pipeline expansion, Regional Energy Access. It is designed for adaptability to future renewable energy sources such as clean hydrogen and renewable natural gas.
• Natural gas should be viewed as a companion to renewables. The Texas weather event in February was just another reminder that we cannot yet rely solely on renewable energy for power. Perhaps at some point, batteries will be able to store enough energy to back-up the intermittency of renewables. Until then, natural gas is a clean burning solution. Please see our essay, “The Texas Power Crisis: Don’t Blame Renewables, Don’t Blame Natural Gas — We Need Both” for details.
• Companies are becoming ESG friendly. All the midstream companies in our portfolio have posted Sustainability Reports and are focused on reducing carbon emissions (albeit, only a few have established specific targets). At the forefront is Cheniere Energy, Inc. (NYSE-LNG), having recently supplied the first carbon neutral cargo of liquefied natural gas (LNG) for delivery to Europe in collaboration with Shell.
• Midstream is directing capital investments toward clean energy. Although investments in clean energy are relatively small for most companies today, we expect that they will grow substantially over time. One exception is Enbridge Inc. (NYSE-ENB), for which nearly 5% of its earnings come from renewables. The company plans to invest $3 (Cd) billion through 2023 and is exploring more than $4 (Cd) billion in renewables and low carbon initiatives post 2023. Kinder Morgan, Inc. (NYSE-KMI) has established an Energy Transition Ventures Group. The company is a major transporter of CO2 and is in a good position to pursue carbon capture and sequestration projects. Other companies have also established teams to explore green opportunities. On a very positive note, management teams are displaying discipline and require a competitive return to justify these investments. Currently, low hanging fruit include the electrification of pipelines with renewable sources of energy, such as solar.
1. Free cash flow generation is accelerating. According to Wells Fargo research, the free cash flow yield of the midstream sector (market cap weighted) is 7.4% in 2021E and rising to 10.0% by 2023E. As such, the resetting of dividends is finally behind the sector; investors have yet to realize (or believe) that dividends are secure.
Note: Free cash flow equates to distributable cash flow minus growth capex
Source: Wells Fargo Securities; May 4, 2021
2. Valuations are compelling. While the S&P 500, Dow Jones Industrial Index, and NASDAQ all continue to reach new highs, the midstream sector has yet to fully recover. Valuations for the broader market appear stretched while the midstream sector trades below its historical average (e.g., current EV-to-EBITDA multiple of 8.4x and 10.3x for MLPs and Midstream C-Corps vs. the 5-year average of 10.4x and 12.5x, respectively, according to Wells Fargo Securities). It has become a challenge to find attractive income paying stocks. In contrast, the midstream sector provides a safe average yield of ~7%.
Source: Wells Fargo Securities; May 4, 2021
3. Credit ratings for the sector are likely to move higher. Why? Companies are utilizing free cash flow to strengthen their balance sheets.
Note: Rating agency leverage metrics reflect the median for Pipeline MLPs and Midstream C-Corps currently under Wells Fargo Securities coverage.
Source: Wells Fargo Securities; May 4, 2021
4. The midstream sector acts as a hedge against inflation. Most midstream companies have cost escalators embedded into their contracts that protect earnings against inflation. Also, their irreplaceable assets should be more richly valued in an inflationary environment.
Energy Lagged in April, But is Still Outperforming Year-to-Date
April was another solid month for stocks and interest rates have eased. The 10-year treasury closed the month at 1.62% – down from 1.74% at the end of the first quarter. Energy was the worst performing sector in the S&P 500 in April, with price appreciation of just 0.46%, even with oil prices gaining $3.94 (6.6%) to $63.49 per barrel (WTI). Utilities performed better (+4.22%), but lagged the S&P 500’s 5.24% price appreciation. Year-to-date, energy is still the best performing sector, up 29.9% while utilities are next to worst, +6.25%, ahead of the consumer staples group. The energy sector is the beneficiary of higher oil prices while the utilities sector is the victim of rising interest rates and fears of inflation;
the 10-year treasury started the year at 0.92%. The S&P 500 is up 11.32% year-to-date.
Against this backdrop, our Infrastructure Income Strategy continues to perform well. Our portfolio generated a total return of 5.2% for April versus 5.3% for the S&P 500 (with dividends included). Year-to-date, the portfolio has returned 18.6% versus 11.8% for the S&P 500. We believe a diversified approach to investments in midstream, utilities and renewables will deliver the best risk adjusted returns. Our Midstream investments appreciated 5.5% in April [(in line with the Alerian Midstream Energy Index (AMNA)] while our Utilities and Renewable Energy holdings beat their respective benchmarks [5.7% and 3.0%, respectively, versus 4.2% for the PHLX Utilities Index (UTY) and -3.8% for the S&P Global Clean Energy Index (SPGTCLR)].
Key Monthly Takeaways
First quarter earnings have generally been better than expected. The Texas power crisis generated windfall profits for several midstream companies, most notably Kinder Morgan, Inc. (NYSE-KMI) and Energy Transfer LP (NYSE-ET) that benefitted by $1.0 billion and $2.4 billion, respectively. These companies were well prepared, their pipeline and storage assets were well-maintained and their marketing affiliates were able to deliver natural gas at extraordinary margins.
The common themes among all companies include the pivot to cleaner energy, sustainability and ESG, and financial discipline. The demands of the investment community can be heard loud and clear.
Consolidation of the upstream oil and gas sector continues. Pioneer Natural Resources (NYSE-PXD) announced its second major acquisition as it consolidates the Permian Basin. It has acquired DoublePoint Energy in a transaction valued at $6.4 billion. The consolidation of the domestic energy industry is welcome as it leads to better financial discipline and less volatility, in our view. Additionally, we believe that larger players will have the wherewithal to be better stewards of the environment. Eventually, the merger bug will migrate to the midstream sector, a sector we believe will be able to realize significant synergies.
No apparent change in Federal Reserve policy. Federal Chairman Jerome Powell has reiterated no intention to reverse the Fed’s easy monetary policy until the economic recovery is complete and inflation rises above its targeted 2% level for a period. Both the Federal Reserve and the U.S. Treasury department believe that current inflationary pressures are due to transitory supply chain and labor issues. However, investors are skittish that the rise in inflation may persist, the economy could overheat, and the Fed will have no choice but to abruptly reverse course. Not a good outcome and perhaps the most obvious risk to the bull market.
Our Stance: The Outlook is Bright and Our Conviction is Stronger — We’re Bullish
Fundamentals for the three sectors in which we invest is encouraging. As we noted before, the midstream sector has returned to financial health. A strong economic outlook bodes well for energy consumption and exports, while oil and natural gas supply should gradually increase. The supply basins likely to lead the way are the Permian Basin, Bakken, Haynesville and Marcellus. The Utilities sector has a long runway of growth tied to investments in renewables and infrastructure to improve system reliability. Our YieldCo holdings also have visible growth with the ongoing rapid penetration of wind and solar power generation.
Energy companies are taking steps to reduce carbon emissions such as using renewable energy to electrify their operations where it makes economic sense. Additionally, they are becoming more vocal and demonstrative of their commitment to ESG and financial discipline. Free cash flow that can be used to return cash to shareholders is the byproduct of financial discipline. The word is getting out that the transition to clean energy requires fossil fuels and renewables such as solar and wind. Fossil fuels are vital to human welfare and, when combined with the rapid adoption of clean energy, can significantly reduce carbon emissions.
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 5.5% (as of 4/30/21) and growth potential of 3% to 4%.The midstream portion of the portfolio has a sustainable yield of 6.6% while utilities and renewables provide yields of 3% and 4%, respectively.