FEN: Midstream Has Potential, But Deteriorating NAV Is Worrisome

Summary

  • Midstream has been coming back in force over the past few months, and many have been wanting to take advantage of it.
  • FEN invests in a fairly diversified portfolio of midstream companies, most of which are quality plays.
  • The fund also invests in electric generation and distribution firms, which are expected to see demand growth over the coming years.
  • The fundamentals for all the companies that the fund invests in are quite solid, but electricity is not as strong as some people appear to think.
  • The fund may not be able to actually afford its distribution as it has seen declining NAV over the past two years.
  • This idea was discussed in more depth with members of my private investing community, Energy Profits in Dividends. Learn More »
Pipelaying crane lowers a section of pipe into a trench. Construction of gas pipeline to new LNG plant. Crawler bulldozer with side boom operation install natural gas pipeline and oil pipes
Photo by Maksim Safaniuk/iStock via Getty Images

Midstream companies, particularly master limited partnerships, have long been favorites of investors who are focused on the generation of income due to their very high tax-advantaged yields and very stable cash flows. The sector fell out of favor during the worst of the pandemic as low energy prices pummeled their market values and most of them cut back on their growth plans in order to preserve capital. We have begun to see a rebound in the sector over the past few months as upstream companies have become confident that the rebound in energy prices is sustainable and have once again begun to increase their production. It may be difficult to pick and choose among the different companies in the sector to take advantage of this rebound, however. One potential solution to this problem is to invest in a closed-end fund that specializes in the sector. These funds give an investor easy access to a professionally-managed portfolio of these assets that can also use a variety of strategies to boost the overall portfolio yield beyond that which you could get on your own. In this article, we will discuss one such fund, the First Trust Energy Income & Growth Fund (NYSE:FEN), which yields a reasonably attractive 8.70% at the current price. I have discussed this fund a few times before (most recently here) so this article will serve as an updated discussion of the fund’s holdings along with its more recent financial report that gives us a better idea of how the fund weathered through last year’s extremely challenging market conditions.

About The Fund

According to the fund’s web page, the First Trust Energy Income & Growth Fund has the stated objective of seeking a high level of after-tax total return with an emphasis on current distributions. This is a very common objective for midstream funds as most of them have something similar. The emphasis on current distributions also makes a certain amount of sense due to the fact that midstream companies provide a high percentage of their total return through the distributions that they pay out. The fund does not specifically state whether it only invests in the common equities of these companies or also in both their preferreds and debt but currently it's only invested in common equities. This is slightly disappointing as midstream preferreds have become an increasingly popular option among those seeking stability but the common equities do admittedly have more total return potential over the long term.

A look at the largest positions in the fund reveals a great many companies that will likely be familiar to anyone that follows the midstream sector. In fact, I have discussed most of these companies in various previous articles:

Source: First Trust

A few of these companies are the same as the last time that we discussed the fund, although some of the weightings have changed. For example, Magellan Midstream Partners (MMP), Enterprise Products Partners (EPD), and TC PipeLines (TCP) were still the top three holdings a few months ago. All three of them have seen their weightings go down over the period though, which could either be a sign of management selling off some of its units or other assets in the portfolio outperforming those three. It's difficult to argue with management’s choices here as both Enterprise Products Partners and TC PipeLines are among the best partnerships in the business. We also see that the allocations to Williams Companies (WMB) and ONEOK (OKE), two natural gas-focused firms with strong growth potential, have been increased. This also is nice to see. Finally, the fund has dumped Westlake Chemical Partners (WLKP) and Plains All American Pipeline (PAA) for Enbridge (ENB) and Altagas (OTCPK:ATGFF). This could increase the fund’s diversification somewhat as both companies are foreign and Enbridge even has some renewable exposure.

As my long-time readers on the topic of closed-end funds are no doubt well aware, I do not generally like to see any asset in a fund account for more than 5% of the fund’s total assets. That's because this is approximately the point at which that asset begins to expose the fund to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk which any asset possesses that is independent of the market as a whole. This is the risk that we seek to eliminate through diversification, but if the asset accounts for too much of the overall portfolio then the risk will not be completely diversified away. Thus, the concern is that some event may happen that causes the price of a given asset to decline and such an event may result in the asset dragging the entire fund down with it if it's too heavily weighted in the portfolio. As we can see above, there are four positions that each account for more than 5% of the overall portfolio. Thus, potential investors in the fund should be sure that they are willing to be exposed to the risks of these companies individually before taking a position in the fund. With that said though, every single midstream closed-end fund that I have analyzed over the past few months had outsized exposure to only a few positions so this is certainly nothing unusual. This one is actually not nearly as bad as some of the ones that I have seen and this should give investors some comfort.

There are several different types of midstream company. For example, some of them focus primarily on the transportation of crude oil and other liquids while others focus on the transportation of natural gas. There are some that only operate short-haul gathering pipelines while others have long-haul interstate pipelines. Each of these different types has different fundamentals. The First Trust Energy Income & Growth Fund invests in all of these different types:

Source: First Trust

This is rather nice because of the diversification benefits that it provides us. We can see that petroleum product pipeline operators are slightly more heavily weighted than natural gas ones. This specifically refers to companies like Magellan Midstream that transport refined products and not to companies that transport crude oil. I would personally prefer to see the natural gas pipeline operators in the top spot. As we will see shortly, the fundamentals for natural gas pipeline operators are somewhat better than for other midstream companies and they overall have more growth potential.

Another interesting thing that we note above is that just over a quarter of the fund is invested in electric power and transmission firms. This is something that some may find unusual for a midstream fund but it's roughly in-line with what the fund had the last time that I analyzed it. This position consists primarily of yieldcos like NextEra Energy Partners (NEP) as well as electric utilities. This could be a good position for the fund to have going forward. There's a growing push to replace some of the things that are currently powered by fossil fuels, such as cars and space heating, with things that are powered by electricity. It will be these entities that benefit if the demand for electricity increases. In addition, many of these entities enjoy reasonably stable cash flows and pay out respectable yields just like the midstream companies do. Thus, it does make a certain amount of sense to include them in the fund even if they are not strictly speaking midstream companies.

Fundamentals Of Midstream And Energy Infrastructure

As I have discussed numerous times in the past, the fundamentals for midstream companies are quite positive. This is particularly true for those companies operating in the natural gas space due to global fears with regards to climate change. These concerns have led governments all over the world to impose a number of incentives and mandates that are meant to reduce the carbon emissions of their respective nations. One of the more popular methods that is being used to do this is to encourage the retirement and replacement of old coal-fired power plants with newer ones utilizing natural gas or renewables to generate electricity. This is because both of these energy sources produce fewer carbon emissions than coal does. According to the International Energy Agency, this will cause the demand for natural gas globally to increase by 29% over the next 20 years. This is more than any other fossil fuel but less than renewables:

Source: International Energy Agency, Pembina Pipeline (PBA)

The midstream companies that the fund invests in should benefit from this even though they do not actually produce any resources. These companies transport and store hydrocarbon resources under long-term contracts with their customers. The payment under these contracts is based on volumes, not the value of the resources, and in many cases the contract will even include a minimum volume commitment that requires the customer to send a certain volume of resources through the midstream infrastructure or pay for it anyway. This is how these companies are able to enjoy relatively stable cash flows through any economic conditions. The fact that these companies make their money off of volumes should make it fairly obvious how they will benefit from this growing demand. The United States is one of the few countries that can increase its production of resources to meet this demand, which will result in growing volumes for midstream companies as they transport these extra resources away from the nation’s various hydrocarbon basins and to the market.

I briefly mentioned the case for electricity producers earlier. Basically, as things like transportation and space heating convert from fossil fuels to electricity, this should cause the demand for electricity to increase. This would naturally increase the revenues and cash flows of electrical utilities and producers. Unfortunately, the U.S. Energy Information Administration throws cold water on this thesis. The agency projects that the national demand for electricity will only grow at a 1% annual rate over the next thirty years:

Source: Energy Information Administration

This is nowhere near the growth rate that we would expect if huge swathes of the American economy were to switch from fossil fuels to electricity. Nevertheless, this does still represent growth and we should see the utilities that are held in the fund deliver slow and steady growth over the projection period. This should result in growing dividend payouts that help to support the distributions that the fund pays out.

Distribution Analysis

As mentioned earlier, the primary objective of the First Trust Energy Income & Growth Fund is to maximize total return with an emphasis on current income. In that vein, the fund pays out a quarterly distribution of $0.30 per share ($1.20 annually), which gives it a distribution yield of 8.70% at the current price. The fund had a very positive track record with its distribution as it was generally able to increase it over time until the crash of 2020 forced it to cut:

Source: CEFConnect

This history would likely be incredibly appealing to most income investors until recently. This fund was certainly not alone in cutting its distribution last year. Many midstream closed-end funds were forced to do the same thing. This is due to the enormous capital losses that the market inflicted on the sector and the fact that there were a few midstream firms that reduced their distributions in response to the uncertainty.

One thing that could prove very concerning about these distributions is the fact that the distributions are entirely classified as return of capital:

Source: Fidelity Investments

The reason that this could be concerning is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. Obviously, this scenario would not be sustainable over any sort of extended period. There are other things that cause a distribution to be classified as return of capital though, such as the distribution of money that was received from a midstream partnership. Obviously, this fund would have a great deal of that. Thus, we should investigate to see how exactly the fund is financing its distributions.

Fortunately, we have a fairly recent report that we can review. The First Trust Energy Income And Growth Fund released its full-year report for the period ended Nov. 30, 2020, recently. This is a much newer report than what was available when I last reviewed the fund so it will give us a much more in-depth picture of how the fund weathered through last year’s challenging market conditions. During the full-year period, the fund received a total of $3,400,928 in dividends and $11,927 in interest off of the investments in its portfolio for a total of $3,412,895. This was not enough to cover the fund’s expenses and overall it had a net investment loss of $14,016,234. It's worth noting though that this figure does not include the payments that the fund received from the partnerships in its portfolio as these would be considered either capital gains or return of capital depending on the situation. The fund did not disclose exactly how much it realized from these companies but overall the fund had $50,352,512 in net realized losses and $46,401,274 in net unrealized losses over the year. This was obviously nowhere close to enough to cover the $35,208,712 that the fund actually paid out in distributions. Overall, it saw its net assets decline by $148,332,680 over the course of the year.

It's not unusual for a midstream fund to have reported losses in 2020 as the steep market declines in the midstream industry devastated most of their asset bases. However, 2020 was obviously a very unusual year so it would behoove us to look at a more typical year like 2019. Unfortunately, here the fund also failed to generate enough money from capital gains and received dividends and distributions to cover its payouts. The fund saw its net assets decline by $27,256,006 over the Dec. 1, 2018, to Nov. 30, 2019, period after accounting for all transactions. Overall, this is worrisome because it could be an indication that the fund cannot actually afford the distributions that it is paying out.

Valuation

As is always the case, it's critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return off of that asset. In the case of a closed-end fund like the First Trust Energy Income And Growth Fund, the usual way to value it is by looking at a measure known as the net asset value. The net asset value of a fund is the current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount of money that the investors would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than net asset value. This is because such a scenario implies that we are acquiring the fund’s assets for less than they are actually worth. Fortunately, that is the case right now. As of April 14, 2021 (the most recent date for which data is available as of the time of writing), the fund had a net asset value of $14.09 per share but it only trades for $13.80 per share. This gives it a 2.06% discount to net asset value. It is not unusual for a midstream fund to trade at a discount but I will confess that this is one of the smallest discounts that I have seen in recent months. It is slightly less attractive than the 2.55% discount that the fund has had on average over the past month so it is possible that we will see a better price in the near future but overall the current one is not bad.

Conclusion

In conclusion, there certainly are some reasons for renewed faith in the midstream sector as it comes off of an extremely challenging year. The fundamentals are quite good driven by growing international energy demand and the fact that these companies tend to enjoy relatively stable cash flows. Unfortunately, this fund’s apparent inability to cover its distributions provides a certain cause for concern and I'm hesitant to recommend it for that reason. The market appears to have faith in it though as it has a smaller discount than most other midstream funds do.

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