Most of our clients have energy infrastructure companies in their portfolios. Known as “midstream” companies, they do not produce energy at the wellhead, known as “upstream,” or refine energy into products sold to the public, known as “downstream.” They make money by owning the pipelines and storage tanks that transport and/or store the energy from the producing fields to refineries or export terminals. In essence, they own the highways that move fossil fuels around the U.S., and to a lesser extent, around the world.
Distribution yields of 8% to 10% are the main attraction of these stocks. In today’s low interest rate environment, that is excellent income. The companies distribute a major portion of the fees they earn to shareholders. In addition, for taxable accounts, distributions are either tax free or mostly tax free as the companies pass along to investors the tax deductions they take for depreciation.
The industry has experienced major change over the last five years. When the price of oil fell radically in 2015-16, investors feared that U.S. production would plummet and that many midstream customers would go belly-up. Consequently, lenders and investment bankers urged them to pay down debt, fund cap-ex initiatives out of cash flow, limit or lower shareholder distributions and otherwise de-leverage their balance sheets. The industry largely took those steps and today balance sheets are in excellent condition.
Currently, their basic business is good. Energy production in the U.S. is at a record high. Much of that production is going to export terminals to be sent around the world. Hence, many midstream companies are generating record cash flows. In the next few years cap-ex spending will plunge. The building of more infrastructure to handle the increased production is mostly complete. With less cash devoted to construction, more cash will be available to increase shareholder distributions.
While industry fundamentals have improved nicely, the valuation of the stocks is down. Investors worry that production in the U.S. is going to reverse itself and go lower. Any number of reasons are given by the bears. A world-wide recession, political action to outlaw fossil fuels, wells pumped dry, electric cars replacing gasoline, the growing (albeit at a slow rate) use of renewable fuels and foreign competition are the chief factors cited. There is also fear that the industry has built too much takeaway capacity that will ultimately force pipelines to operate at sub-par levels. We disagree with the bears. World-wide, demand for fossil fuels continues to grow. While the rate varies, growth continues, powered by population growth and the universal quest for a higher standard of living. As people simply drive more, gasoline consumption in the U.S., China and India continues to set records. Supplies of energy are also in question as to location. Recent drone attacks on Saudi Arabian oil fields and Iranian tankers favor the U.S. industry and the companies that operate the infrastructure. Our strategy is to hold the stocks and earn high income while we wait for the negativity clouding the space to disperse. We are encouraged that the stocks sell at historically low multiples of cash flow and replacement value. Recent transactions in the private equity arena are valued nearly 30% higher than publicly traded valuations. Long term, we see value in the midstream sector and will continue to hold or add to positions.