The outlook for the midstream industry looks bright. Nearly everywhere, oil and gas volume increases are improving pipeline throughput - almost too much. For the majority of the North American basins, takeaway capacity is now tight. That means higher operating leverage and a continued need for infrastructure investment - both factors that should be clear positives for the industry. However, the entire sector continues to trade at a discount to recent historical averages despite a stellar stock market. What's the deal?
By any measure, midstreams are cheaper today than they have been over the past five-year period on nearly any measure. This, in my view, makes the sector extremely attractive. While there is certainly a case to be made for a return to the mean for the entire grouping from a pricing perspective, I also think there will be clear winners and losers going forward. It is important to have a discussion on which companies within the group have the best potential upside. With dozens of options, how is one to choose? Other than me doing it for you - which is, of course, an option - I think exploring what has occurred over the past few years and whether that trend will continue will help investors reach a reasonable conclusion. After all, the entire midstream market is evolving. Access to capital, consolidation, and simplification are all major themes driving investor interest, particularly among larger institutional investors. All of those impact investability, and we'll go through each of those one by one.
Capital Spending Trends
The midstream industry, whether that be through the master limited partnership ("MLP") or C-corp structure, is one that is predicated on growth. That has always been the value proposition to justify the existence of these firms, many of which can trace their roots back to exploration and production ("E&P") companies that spun out or sold these assets in the hope that they would be valued more fairly on an independent basis.
The pitch has always been that North American energy production was undergoing a revitalization and that infrastructure would have to be built out to handle it. Growth has to be paid for, and doing that in the quick fashion needed meant either issuing equity or raising debt. The tacit understanding between shareholders like you and me and these companies was that whether we were diluted (secondary stock offerings) or leverage was ramped (higher interest expense), we would be rewarded with higher distributable cash flow ("DCF") per unit that would be passed along to us in some fashion either directly or indirectly.
Between 2009 and 2013, debt and equity raised by midstream firms catapulted from $16.6B to $76.8B, a near four-fold increase. The shale boom was on. However, appetite clearly waned as oil prices fell from highs above $100/barrel in 2014. Valuations collapsed, and secondary equity issuance to fund new pipeline infrastructure has been cut in half; it just is not accretive in most cases, and secondaries are now (generally) very poorly received by the markets. To compensate, debt funding is up as credit markets pick up the slack. However, with debt/EBITDA leverage hovering at 4x for the sector, there is little leeway for additional borrowing. Options are thin.
That has created more need for hybrid financing. Several years ago, preferred equity sales, sales of assets back to the general partner with buyback provisions, and other schemes were not common. However, in 2018, SemGroup (SEMG), USA Compression (USAC), DCP Midstream (DCP), NuStar Energy (NS), Buckeye Partners (BPL), and others all issued alternative financing to raise capital. This trend has continued this year. The challenge for the industry is how it intends to fund future growth that is estimated at more than $100B over the next five years at a time when issuing common equity is dilutive, alternative financing methods are barely accretive, and (in many cases) a lack of balance sheet capacity exists.
One answer to the above conundrum is scale. Access to capital can be solved with simply growing larger: entities with more diverse asset bases tend to get better credit ratings and attract greater institutional interest. Institutional interest has waned in the sector for years now due to a confluence of events: poor corporate governance, weaker long-term outlook, lower growth rates, and the reality that underlying commodity prices do, in fact, matter. The largest investors in the space that remain, whether that be hedge funds like Tortoise Capital, Harvest Fund Advisors, or Kayne Anderson or fund providers like Vanguard and Blackrock, tend to gravitate towards the mega caps. The result? A basket of large-cap midstream operators (think Enbridge (ENB), Kinder Morgan (KMI), Energy Transfer (ET), Williams Companies (WMB)) has significantly outperformed the Alerian MLP Index (AMLP). Dabbling in small caps has been, in most cases, a losing proposition.
*Source: Wells Fargo, February 2019 MLP Research
Much of these large midstreams have been the result of early consolidation. Enterprise Product Partners (EPD), for instance, merged with GulfTerra in 2004, TEPPCO and Enterprise GP Holdings in 2009, Duncan Energy in 2010, and Oiltanking Partners in 2015 on its way to having the second largest market cap in this market behind Enbridge - a firm that decided to roll up all of its daughter firms into itself in recent years.
This kind of activity will only accelerate. In 2018 and 2019, we've seen the announcement of the merger of Western Gas Partners and Western Gas Equity Partners, Dominion Midstream (DM) being rolled back up by Dominion Energy (D), EQM Midstream (EQM) taking out EQT GP Holdings (EQGP) after acquiring Rice Energy earlier in the year, NuStar Energy buying out its GP, Energy Transfer Equity merging with Energy Transfer Partners, and many other such transactions. Investors have to ask themselves whether the large-cap outperformance trend will continue or if it makes sense to buy into smaller midstream firms that might not have barriers to a takeover (heavy GP ownership).
The Move Away From The Traditional MLP Model
One of the key trends in MLPs over the past two years has been a move away from, at least up until recently, was the norm for the subsector: high distribution payouts. Instead, self-funding, higher coverage ratios, and an emphasis on a stronger balance sheet have taken hold. Firms such as Magellan Midstream Partners (MMP), Crestwood Equity Partners (CEQP), Enterprise Product Partners, Kinder Morgan (KMI), MPLX (MPLX), Williams Companies (WMB), Plains All American (PAA), ONEOK (OKE), and others have all committed to change. These companies have all worked to eliminate the traditional incentive distribution rights ("IDR") structure, cut or suspended distribution raises to increase retained capital, and have put into place programs to delever the business.
Wonder why midstreams continue to cut payouts to shareholders? It works. Since 2017, the above group is up around 7% collectively versus a nearly 20% decline for the Alerian MLP Index. For firms that still retain the IDR structure - Shell Midstream (SHLX), DCP Midstream (DCP), Delek Logistics (DKL), Summit Midstream (SMLP), and others - the clock is ticking on reform. Investors, tired of years of shenanigans from GPs (American Midstream (AMID), Hi-Crush Partners (HCLP), TransMontaigne Partners (TLP), SunCoke Energy Partners (SXCP)), just have written off the GP/LP model as dead. Even for GPs that have treated shareholders well (Royal Dutch Shell (RDS.A), Westlake Chemical (WLK)) are being cast aside for standalone assets. This is particularly true for those companies where the IDRs are currently "in the money", so to speak, and payouts are being made to the GPs.
The midstream industry looks poised to perform. The majority of North American basins will have tight takeaway capacity over the next several years. This gives the opportunity for earnings upside. As the sector undergoes restructuring (simplification, self-funding, IDR elimination), I expect institutional capital flows will improve over time. Private equity is a likely backstop for values at current levels (see BlackRock interest in Tallgrass Energy (TGE)). Outside of a collapse in oil and natural gas prices driving lower drilling activity, the upside looks to be there. While a rising tide will lift all boats, I think investors can end up on the better boats with a little hard work and due diligence.
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Disclosure: I am/we are long SHLX, EQM, SEMG. 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.