We Are Buying Midstream Hand Over Fist
Feb. 03, 2021 8:30 AM ETAMLP, EBBNF, EBRGF...3 Comments5 Likes
Summary
COVID-19 has led to energy demand disruption and hit the midstream space pretty hard in 2020.
That said, we believe that - with large scale vaccinations being administered - there is a clear light at the end of the tunnel.
Midstream fundamentals and valuations have never been more attractive.
We love investing in the midstream sector because many of its businesses fit in well with our investment philosophy of investing in businesses with understandable business models, years of proven profitability and free cash flow generation, and a shareholder-friendly dividend policy
Right now, we find the risk-reward to be particularly attractive in the sector for the following three reasons:
1. Exceptionally Attractive Valuations
Their valuations are extremely opportunistic right now:
Best Yields: There is no better place to get yield in today's marketplace than in the midstream sector. Midstream index (AMLP) yields are 2-3x greater than REIT (VNQ) and utility (XLU) index yields and 5-10x greater than stock (SPY) and bond (BND) index yields. Furthermore, despite interest rates (GOVT) hitting historic lows and many midstream businesses slashing their distributions in 2020 to free up cash flow for debt reduction and buybacks, midstream index yields sit 130-200 basis points above their 5-year averages:
source
Lowest Multiples: Furthermore, midstream indexes offer the lowest multiples and trade at a steep discount to their historical averages in contrast to virtually every other sector which trades at inflated multiples due in large part to record low interest rates.
source: Alerian EV/EBITDA EV/EBITDA (10-YR AVG)
Midstream MLPs 8.7x 11.5x
Midstream Sector 9.8x 12.2x
S&P 500 12.7x 10.3x
Historic Yield Spreads: Finally, MLP yield spreads are at all-time highs relative to both the stock market and bonds:
Chart
Data by YCharts
2. Increasingly Strong Moats
Increasing regulatory and legal roadblocks for major pipeline projects and the recent anti-pipeline actions by the Biden administration only increase the moats for blue chip fully-integrated midstream businesses such as Enterprise Products Partners (EPD), Enbridge (ENB), and Kinder Morgan (KMI). With fewer new pipelines being built, their existing networks will have less competition, thereby sustaining their volumes and pricing power.
3. Resilient Fundamentals
Furthermore, though the entire midstream sector suffered a scare, significant market volatility, and even some headwinds to otherwise quite stable cashflows, overall the industry seems to have emerged from 2020 in nearly as good of shape as it entered.
For example, as part of a sector-wide trend, all five of our HYI midstream picks are projecting to be free cash flow positive after distributions in 2021. Some of them are even engaging in equity buyback programs.
All of our picks report that the energy crash in 2020 actually strengthened their customer base moving forward as it weeded out the weak contracts and put all current contract terms on much firmer footing. Furthermore, they expect it will pave the way for further consolidation in the upstream energy sector, leading to stronger business models and balance sheets and therefore stronger contracts for midstream businesses.
In part due to many projects coming online and the sharp rebound in energy prices, but also due to the resilience of the business model,
WTI crude oil prices
midstream companies across the sector have remarkably stable or even favorable EBITDA estimates for 2021 relative to 2019 results.
Why Mr. Market Doesn't Like Midstream
If midstream businesses are such a great investment right now, why the deep discount?
1. Energy Market Volatility: There is no question about it that COVID-19 impacts have reduced demand for fossil fuels, which have in turn reduced volume demand through midstream pipelines.
Furthermore, the rough ride for oil prices over the past 6 years has limited the midstream sector's growth opportunities and ultimately meaningfully damaged Mr. Market's sentiment on the entire midstream space.
Chart
Data by YCharts
While strong fully-integrated pipeline networks like those we hold at High Yield Investor have remained relatively insulated from the worst effects of the energy industry carnage, their cash flows have still taken a slight hit and their future growth prospects have definitely been reduced.
2. Renewable Energy's Rise: As President Biden's recent decision to nix the Keystone XL pipeline project indicates, the increasing political and cultural emphasis on moving towards renewable energies and away from fossil fuels is impacting the midstream pipeline industry as well. As a result, Mr. Market is concerned about the future growth prospects and even viability of the midstream business model.
Furthermore, the rise of ESG investing has caused many investors and even institutions to shun any businesses that are in any way related to fossil fuels, resulting in reduced demand for midstream equity.
3. K-1 Tax Form: Many midstream businesses (the MLPs) issue a K-1 to common and preferred equity investors. Given that many foreign investors face a prohibitively high withholding tax on K-1 issuing securities and many others do not want to deal with the headache of filling out the tax form, this further reduces demand for midstream equity.
Why We Are Optimistic Here
In addition to the opportunistic valuation, we think the fundamentals of the industry are much more resilient than the market is giving it credit for.
As has already been stated, the COVID-19 hit to midstream has not been as pronounced as what has been witnessed in other sectors and the businesses themselves are healthier than ever. Furthermore, vaccines are rolling out and we fully expect the worst of COVID-19 to be over within a few months, with society returning to mostly normal sometime over the next year. As a result, we expect energy demand to recover significantly over the next 6-12 months.
Of course, concerns over renewable energy's rise and President Biden's hostility to fossil fuels and the pipeline industry are legitimate and should not be ignored.
However, the cancellation of the Keystone XL project and new restrictions on oil and gas leasing on federal lands was fully expected. Furthermore, these actions have minimal near-to-medium term impact on our fully-integrated midstream holdings and in fact even come with the silver lining of reducing competition for their well-diversified businesses.
Additionally, we believe that demand for fossil fuels and natural gas in particular will not be declining significantly for a long time as the International Energy Agency's World Energy Outlook 2018 estimates that global energy demand will have grown 25%+ by 2040. With much of this demand coming from developing markets overseas, export infrastructure held in many midstream portfolios should see strong demand in the years to come.
Furthermore, ~50% of the world’s oil consumption is for industrial uses and lacks a viable replacement.
As a result, even a worst-case scenario sees fossil fuel demand only declining very slowly.
See the source image
source
An additional cause for optimism is that many midstream businesses have prudently fortified their balance sheets by capitalizing on increasingly cheap debt to refinance and extend their debt maturity dates and even pay down debt to deleverage. The vast majority of midstream businesses are not only self funding all CapEx and reducing CapEx via high grading investments, but are generating substantial amounts of free cash flow after paying out hefty distributions.
As a result, today we see a sector filled with investment grade balance sheets, record high spreads between distribution yields and interest rates, and even some buying back equity.
Finally, the superior value and yields being offered by the sector should continue to attract strong demand from private equity investors and others needing income in a yield-less world with sky-high valuations everywhere else.
Investor Takeaway
In a sector ripe with opportunities, we prefer to lean towards investment grade balance sheets or preferred equity, well-covered yields, and fully-integrated asset portfolios that have the best chance of weathering headwinds while still offering us plenty of upside potential and lucrative income.
We believe this approach will lead to long-term alpha in the midstream space and that the sector as a whole provides us with a very favorable risk-reward profile at present.
Disclosure: I am/we are long EPD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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