OCTOBER FOCUS: Midstream MLPs - Stocks in Early Stage of Upcycle


Midstream MLP Stock Investment invest how to

Midstream MLP stocks sold off recently, a startling turnabout after a rebound took sector prices to the highest level in almost two years. Are the bad old days back? That is a natural question to ask since memories of the energy sector’s terrible return history are still fresh. I want to address some questions midstream investors are raising.

How do I help my clients deal with the price swings?

This kind of volatility is hard to take, but there are ways to address it and calm nerves:

  1. Keep the focus on the cash distributions. Talk about MLP investments like they are private companies, where the monthly receipt of a cash payment is the measure of success. Private companies do not get marked-to-market every day. In a perfect world, your clients could put the MLP shares in a separate account that they would not have to look at daily.

  2. Manage the position size to let your client sleep well at night. If the normal position weighting is 5% of the portfolio, make the MLP investment half of that. The income pickup from the relatively high yield may still be significant in a diversified portfolio.

  3. Dollar-cost average to build a position. Profit from the volatility by adding to the position on these sudden selloffs. We think a long upcycle is now underway, underpinned by buoyant commodity prices and an extended period of underinvestment in natural resources.


Are short-term price swings just a distraction from the long-term profit potential?

Business cycles in the energy sector are very long, driven by periods of over-investment and under-investment. The last time crude oil prices were at the current level was around October 2014. The over-investment phase of the cycle extended from about 2014 to 2020. Crude prices collapsed from over $100/barrel to a briefly-quoted price of less than $0, marking the bottom of the cycle.

Few made money in those years, and new investment dollars dried up. Hundreds of billions of dollars have NOT been invested in the oil and gas industry in recent years, and now the commodities are in short supply. High prices reflect the shortage.

It should be noted that midstream companies are positioned very differently today than they were in late 2014. At that time, they were considered growth companies that could support never-ending distribution increases. Investors were lining up to provide the capital needed for the next big expansion project. Opportunities for growth seemed open-ended.

Today the environment is one where capital budgets are cut to the bone, and energy companies demand to get paid for risk-taking. Animal spirits are not driving a pell-mell rush to drill like seen in the past; financial commitments are made with discipline. Consequently, returns on invested capital are likely to be higher and more sustainable. We think shareholders will be rewarded.



What is the outlook for cash distributions?

We think accelerating distribution growth is the coming story. Our view is that the midstream energy sector is in the early stage of an upcycle. After eight years of lousy investment returns, we look for a reversion to the mean, to an extended period of improving returns.

Midstream companies strengthened their finances during the pandemic. Deferral or cancellation of expansion plans meant they had a boost in free cash flow. They focused on increasing operating efficiencies, and distribution cuts made more cash available for debt repayment. We think strong balance sheets, reduced debt, and shareholder-friendly actions like stock buybacks signal the start of the upcycle.

It is worth noting that about 81% of the midstream index (AMZI) is comprised of companies that are growing their cash distributions right now. Most of that group grew their distributions right through the pandemic, while others are announcing increases after having had to cut. The balance is in companies that cut and are still using free cash to reduce debt. The index yield was 8.05% on July 11.

Importantly, US production of crude oil and natural gas is key to keeping the global markets in balance. Production of crude may rise a million barrels per day this year, nearing the peak of 13 mb/d reached in 2019. Further production increases are expected in 2023-2024. Increasing volumes and pipeline utilization rates benefit midstream companies.

The global energy markets are in a precarious balance. Inventories of crude oil and natural gas are near record lows, and they are being drawn down further. New supplies are needed to normalize the markets and avoid upward price spikes. This fundamental position is a wind at the back of the US energy industry. We think government policy changes to encourage more resource development are inevitable.

Does the green energy revolution signal the end for carbon-based fuels?

Climate activists control the media, and the message they send unsettles investors in the traditional energy sector. Our view is that big change always takes longer than expected. We think carbon-based fuels will play a key role in the global economy for many years.

My colleague, Jay Hatfield, likes to remind me that, as an investment banker, he did the IPO of the first fuel-cell company to go public in the late-1980s. The technology was expected to change the world by the end of the next decade. It did not happen. That was more than 35 years ago and predictions for the demise of fossil fuels keep coming.

But the tide seems to be shifting. In just the last month, the leaders of the G7 took a giant step back from the climate protection goals they had set in prior meetings. Germany is restarting coal-fired power plants, while its citizens are stockpiling firewood to get through next winter. Dropped was a commitment to make half of all vehicles sold zero-emission by 2030.

In another surprise, the US Supreme court ruled that the EPA cannot set controls on carbon emissions without Congressional approval. Adding to the momentum, the EU Parliament just voted in favor of calling natural gas and nuclear power “green” or “sustainable” sources of energy.

The promised overnight transition away from carbon-based fuels is hitting some speed bumps. We think we will see more such developments in the coming years.


 

DISCLOSURE The information contained herein represents our subjective belief and should not be construed as investment advice. The information and opinions provided should not be taken as specific advice on the merits of any investment decision. Investors should make their own decisions regarding any investments mentioned, and their prospects based on such investors’ own review of publicly available information and should not rely on the information contained herein. Infrastructure Capital Advisors, LLC nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein. This article is not an offer to sell, or solicitation of an offer to buy any investment product or services offered by Infrastructure Capital Advisors, LLC, (“ICA”) or its affiliates. ICA, will only conduct such solicitation of an offer to buy any investment product or service offered by ICA, if at all, by (1) purported definitive documentation (which will include disclosures relating to investment objective, policies, risk factors, fees, tax implications and relevant qualifications), (2) to qualified participants, if applicable, and (3) only in those jurisdictions where permitted by law. This article includes information based on data and calculations sourced from Bloomberg and index constituents in the Alerian MLP Index. We believe that the data is reliable, we have not sought, nor have we received, permission from any third-party to include their information in this article. Many of the statements in this article reflect our subjective belief.


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