Antero Midstream: Your Protection From Inflation

Oct. 13, 2021 11:59 AM ETAntero Midstream Corporation (AM)44 Comments

Summary

  • Inflation is high on the agenda not only in the US, but around the world. I am exploring the underlying reasons that, to this day, are heavily influencing rising prices.
  • The midstream oil and gas business is one of the most stable and profitable in times of high inflation.
  • Antero Midstream is one of the most exciting companies in its sector - 8.2% dividend yield, strong balance sheet, momentum tailwinds.
  • Despite the risks involved, I recommend buying AM at current levels.

Инфляция написана газета

CasPhotography/iStock via Getty Images

Thesis

In this article, I examine the extent to which the risks of high inflation in the U.S. (and the rest of the world) are justified and the key characteristics of midstream oil and gas companies as defensive stocks in this case. Then I turn to Antero Midstream Corporation (NYSE:AM) - this company is one of the market leaders in my opinion and can be a good defensive investment if/when inflation is rising.

What signs of rising inflation we can see?

Let's start with a quick definition:

Inflation is a decrease in the purchasing power of currency due to a rise in prices across the economy.

Inflation requires prices to rise across a "basket" of goods and services, such as the one that comprises the most common measure of price changes, the consumer price index (CPI). When the prices of goods that are non-discretionary and impossible to substitute-food and fuel-rise, they can affect inflation all by themselves. For this reason, economists often strip out food and fuel to look at "core" inflation, a less volatile measure of price changes.

Source: Investopedia

Well, with this definition in mind, let's take a look at how inflation (including the "core" one) behaved in the United States over the past year, that everyone began to talk about it so vividly:

US inflation rate and Core inflation rate
Data by YCharts

According to TradingEconomics, "the annual inflation rate in the US eased to 5.3% in August from a 13-year high of 5.4% reported in June and July, matching market expectations." The target rate (long term) of the Federal Reserve, as we know, is 2% for "core" inflation (twice fewer compared to what we face now). Although the Bureau of Economic Analysis' forecasts (as of May 19, 2021) called for a slight deviation from the target, actual inflation turned out to be much higher than expected.

Actual and forecasted headline PCEPI

What caused this deviation and why it's not over yet?

Here are the most, from my point of view, main culprits, which continue to push the inflation rates upward:

1. The ongoing chip shortage. On the example of the automotive industry, we see how much the prices have increased even for used cars, which is primarily due to a) a widespread drop in production and b) empty dealer warehouses (no production - no new vehicles - no inventory). A similar picture is observed in any industry, the production component of which is closely related to the use of microelectronics (in the modern world, this is every second industry). The purchase of equipment, the price of which has risen significantly, affects the amount of depreciation: the more expensive you buy, the more you amortize. As you know, depreciation, regardless of the accounting method used, is taken into account in the cost of goods sold (COGS), therefore, when selling, a manufacturer either sells with a lower margin than before or increases the price to maintain the previous marginality levels. As we can see, according to analysts' expectations regarding the upcoming 3Q reports from S&P 500 index companies, manufacturers choose the second option.

For the third quarter, S&P 500 companies are projected to report earnings growth of 27.6% and revenue growth of 14.9%.

Source: FactSet

Therefore, what was partly the cause of growing inflation in recent months has not lost its relevance today - we know with certainty that the chip shortages will persist in the coming quarters and perhaps into 2024. The timing, in this case, is meaningless, but the big picture points to one thing - this influencing factor will continue to drive inflation higher regardless of what action the Fed takes - it is simply beyond the government's control.

2. Fuel & commodities prices. Over the past 6 months, natural gas prices in the United States (based on Henry Hub NG spot price) have increased by almost 157% and keep on going higher:

Genry Hub Natural Gas spot price % change
Data by YCharts

The front-month contract for the European benchmark for natural gas - Dutch TTF hub - has risen almost 400% since the start of the year, according to CNBC.

Commodity prices as a whole are up 31.43% YTD, according to Bloomberg's data.

Bloomberg Commodity indexSource: Bloomberg Commodity Index

These prices could not but pass on to the end buyers, increasing the prices of goods, the production of which is directly or indirectly related to the use of commodities. Rebuilding production capacity (or simply maintaining it) requires a lot of electricity, most of which is generated by burning natural gas. If NG prices rise, the COGS increases and we again come to the same conclusion as in discussing the first "culprit".

The only question is whether this energy crisis, in which we are all right now, will continue further? The economic recovery from the pandemic recession, "unusually cold winter in Europe that drained reserves, a series of hurricanes that forced shutdowns of Gulf oil refineries, a turn for the worse in relations between China and Australia that led Beijing to stop importing coal from Down Under" are cited as the main causes of the current crisis [Source: Washington Post]. But if this is the case, then the crisis will end immediately after the cold weather passes and China reaches an agreement with Australia, right?

I think it is a little more complicated than that. The question to be answered is, "Why are the reserves in Europe so rapidly exhausted?" The habit of relying on Russian gas and the pressure on existing energy companies to abandon coal mines, switch to green energy, etc. has paid off - companies have started to invest less in developing new fields. There is simply nothing left to mine when demand is growing as it is now.

Even if this inflation is "transitory", companies are going to do their best to retain the price hikes of the last year. Commodity prices should be an exception, but environmental policies are making that less likely. The push for net zero emissions from traditional energy companies means they aren't investing to discover new reserves. Banks have been pressured to not lend to fossil fuel companies, and the Fed is being pressured to make that more than a suggestion through capital requirements. That is the obvious implication of adding a climate mission to central banks' remit. There's a reason oil and natural gas prices are where they are, and I do not expect the supply side to get better anytime soon. And reducing demand isn't merely a matter of building more windmills and solar farms, as Europe and the UK have discovered - to their citizens' dismay.

Source: "Weekly Market Pulse: Inflation Scare?"

Extreme weather conditions, hurricanes, and other "delights" of climate change will continue to lead to these kinds of crises until governments loosen their grip. This crisis, I expect, may continue way after the approaching winter.

3. Transportation costs. Ship outages at ports around the world (especially in China) result in supply disruptions and higher transportation costs - regardless of what kind of cargo you are shipping (bulk or container).

Daltic Dry IndexSource: Baltic Dry Index, TradingEconomics.com

HARPEX Chart
Data by YCharts

While the shares of shipping companies are experiencing a continuous rally, the current situation again affects the cost of sales of imports in the United States, causing inflation. The impact of the spread of the coronavirus on the actions of the Chinese (and not only) authorities can hardly be overestimated. I do not think that the CCP will soon abandon the mandatory quarantine for ships arriving at ports so that the delta variant does not spread throughout the country.

Summing up all of the above, I believe that inflation has every chance to remain on the agenda for a long time because the fundamental reasons that provoke it still strongly influence the course of events.

Why midstream companies in general and Antero Midstream Corp. in particular?

One interesting thing about midstream oil and gas companies is that they pay huge dividends. According to Seeking Alpha's screener (Oil and Gas Storage and Transportation sector), the median dividend yield (TTM) equals 6.49% (169 companies in the sample). This is quite a lot because, during inflation, investors want to keep in their portfolio stocks that can help weather the storm and not lose the "real value" of their money. Antero Midstream stands out in this regard - TTM's dividend yield is 9.70%, which is significantly higher than the sector's median value.

Also, according to AAA "the national [US] average for a gallon of regular unleaded stands at $3.27", which is $1.09 more than a year ago and 10% higher than last month. The beauty of owning midstream O&G companies during such periods lies in their business model - AM and its peers simply transfer all the costs to end-consumers, taking away a higher commission and guaranteeing themselves unprecedented EBITDA values.

Over the past year, Antero Midstream has outperformed the rest of the companies in the sample in terms of return by a factor of 2.5 (compared to the median), so many might think that the stock is currently overbought. However, I do not hold that opinion. If we broaden the horizon of analysis, we will see that AM has lagged its peers not only in "price" terms but also in "total return" terms three times over the past 3 years:

Antero Midstream compared to median

Source: Seeking Alpha data, author's calculations

Therefore, Antero Midstream simply returns everything that it missed over the past few years, continuing to build momentum. I'm not an adherent of technical analysis, but if we look at the chart, we can see that the current stock price accounts for 97.9% of its 52-week peak, crossing the previous high and forming the so-called "Darvas Box":

AM stock chart

Antero Midstream stock chartSource: Investing.com, AM chart, author's notes

With the catalysts available, I think that AM's long-term downtrend has finally broken and now the stock will rise in the near future as long as the energy crisis remains on the agenda.

The financial side of the company also gives confidence in the future - the debt burden is gradually decreasing, EBITDA is growing, profitability continues to remain at the proper level.

AM long term debt, EBITDA, return on capital employed, & return on equity
Data by YCharts

A very important point for the entire midstream segment, and not only AM, is that the revenues of most companies are contracted including inflation escalators. Hennessy Funds gives an example:

FERC-regulated interstate liquids pipelines can increase tariffs by a percentage equal to the change in the producer price index for finished goods (PPI-FG) plus 0.78%.

Source: "The Benefits of Midstream Companies in an Inflationary Environment"

According to AM's recent 10-Q, "all of the company's revenues are currently derived from service contracts with customers and are recognized when the company satisfies a performance obligation by delivering a service to a customer".

Under the gathering and compression agreement, the Company receives a low pressure gathering fee, a high pressure gathering fee and a compression fee, in each case subject to annual CPI-based adjustments. In addition, the agreement stipulates that the Company receives a reimbursement for the actual cost of electricity used at its compressor stations.

Source: AM's 10-Q

So we can assume that AM is very well positioned and financially stable in today's market conditions. If anything, investors who buy the stock now are unlikely to see a dividend cut anytime soon. That being said, they will have some sort of upside option if the energy crisis continues in the near future, as I expect.

I also compared AM's key market multiples with the sector and concluded that the company as a whole was valued fairly, perhaps even with a small discount:

AM P/E TTM & EV/EBITDA compared to median

Source: Seeking Alpha data, author's calculations

In summary, I believe AM deserves your attention as one of the best ideas for saving your portfolio from inflation.

Risks of my thesis and takeaway

The biggest risk of my thesis is the statement that inflation is highly probable. We do not know how long what we see today in the economic reports will last. I have given only part of the argument that the continuation of the rise in prices is not something that will end quickly. Perhaps the government has a special plan that we do not know about (or just I don't know) and in a couple of months, the price growth will stabilize.

The next risk is in my approach to business analysis. I start with a price action pattern and only then deal with the company's financials. The fact that the stock has outpaced the sector's median return by a couple of times may indicate that AM has nowhere else to grow. Moreover, some multiples in comparison with the sample's median values still speak of overvaluation of Antero Midstream:

AM compared to median in EV/sales, EV/EBITDA, Price/Book, Price/Cash Flow

Source: Seeking Alpha data, author's calculations

However, I believe that the premiums to the above ratios are due to the higher growth of the AM's operating indicators and its overall financial stability.

Therefore, despite all the risks, I expect AM quotes to rise in the foreseeable future, relying on some macroeconomic/idiosyncratic catalysts. Investors looking for inflation protection should take a look at this idea given the company's good dividend yield.

Happy investing and stay healthy!

This article was written by

Danil Sereda profile picture
2.57K Followers
Discover What Wall Street Is Buying

Chief investment analyst at a small Singapore-registered family office. Mainly focused on special situations, IPOs, and undercovered/hidden stocks.


BS in Finance. In my bachelor's thesis, I looked at finding the best statistical/machine learning methods to predict underpricing of Initial Public Offerings (IPOs). A brief summary of my findings: using the KNN method, you could add about 24% of alpha compared to the average return of each initial public offer. In other words, with the AI algorithm I developed, it was possible to distinguish good IPOs from bad IPOs, where the average underpricing of selected companies in the test sample was 64.5%, while the overall average underpricing would be only 41.39%. More can be found here.


Ranked in the top 4% of financial bloggers by Tipranks (as of June 17, 2022, compared to the S&P 500 Index over a 1-year period). 


**Disclaimer: Associated with Oakoff Investments, another Seeking Alpha Contributor

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in AM over the next 72 hours. 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.

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