The 'Sweet Spot': These Pipeline Companies Just Got The Goldman Seal Of Approval

Includes: EPD, MMP, NDRO, PAA, WMB
by: Kent Moors

Nothing like having the world's most eminent (or is it notorious) investment bank confirm what we've already been saying for a year

Last week, Goldman Sachs (NYSE: GS) reminded us that they are bullish on the oil and gas pipeline sector by upgrading a number of stocks that have been prominent features of our discussions on the sector.

Goldman analysts added a number of pipeline firms to their "Conviction Buy" list. They added Williams Companies (NYSE: WMB). They also raised a number of additional stocks to the "Buy" list, including Plains All American Pipeline (NYSE: PAA), and maintained "Buy" ratings on Enterprise Products Partners (NYSE: EPD) and Enduro Royalty Trust (NYSE: NDRO), and Magellan Midstream Partners (NYSE: MMP)

It's not surprising to us that Goldman Sachs is suddenly so bullish on the pipeline industry. After all, my colleague Kent has been touting the best-known secret in the markets for more than a year.

And, once again, here it is.

The Sweet Spot in Oil and Gas Pipelines Companies

If you want to make money in energy investing, you need to park yourself right in the middle of the supply chain. By doing so, you're far less susceptible to price fluctuations in the underlying commodity, and you are able to collect easy profits from the growing demand in fuels.

I'm talking about midstream companies – those that connect the "upstream" exploration and production companies to the "downstream" retail, refining, and marketing channels, and provide vital services in transportation, storage, and processing.

Simply put, this is the "Sweet Spot" of energy investing.

Midstream MLP operations in particular generate fee-based revenues on fuel volumes going through the pipeline, so these companies enjoy less exposure to price volatility – a very welcome sign to the risk-adverse investor.

And it's these partnerships that typically pay higher yields in the form of distributions to shareholders and offer the ever-tantalizing share appreciation opportunities.

Of course, choosing the right MLP is always a challenge, even if you're a Goldman analyst. That's why, just a few months ago, I wrote at length about the best way to make that decision.

Goldman used this very metric in its own analysis before making those recent recommendations.

Look at Distributable Cash Flows

Goldman Sachs conducted thorough analysis of each company's potential to transport oil and gas liquids through their network of midstream services. Volume is always an important metric, as is the proximity to the ever-expanding shale fields across the United States.

But the reality is, the ability to simply transfer or store oil and gas is not enough to justify buying shares in any of these midstream companies.

There's another important metric you need to keep your eye on. Cash flow.

Cash flow is the most important measurement of how to analyze Master Limited Partnerships or other midstream companies to obtain the best distribution returns.

Many of these companies have very strong yields and pay them out in the form of quarterly distributions to shareholders. Yet these distribution payments must be funded by the companies' cash on hand. We don't want to see that they are taking on new levels of debt in order to do so.

Not only will that impact the reliability of the distribution levels; it can greatly impact the share price, too.

By paying attention to cash flows, you're able to accurately measure how a company can account pipeline depreciation or other ways that the partnership reduces its tax burden and pass profits along to investors.

And those profits are what we really care about at the end of the day.

But remember, the MLP will not pay out all of its cash distributions at once. It's necessary for these partnerships to retain some of their resources. Management may need to expand operations or ensure that it can continue to pay its distributions at the same yield level in the future (or even raise them).

And a strong history of increasing yields and the company being able to meet its dividend obligations should be a signal of good things to come.

Midstream MLPs remain a major advantage for the income-seeking investor.

Just one note: You'll want to find a yield that's in (or close to) the double digits.

And if we know the best ways to measure their potential, that's even better.

Goldman Sachs is telling us what we already knew.

But there's nothing wrong with that. It's good to know that one of the world's smartest banks has taken such a keen interest in the oil and gas pipeline sector along with us.

Disclosure: None

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