Energy Midstream: The Best High Yield Opportunity Of 2022

Summary

• With inflation soaring, interest rates still stuck near historic lows, and macroeconomic and geopolitical uncertainties abounding, income investing is harder than ever.
• However, there are still a few small windows of opportunity remaining.
• We discuss one that not only offers incredible value, but is also defensive in nature and is resistant to inflation.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »

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With inflation soaring, interest rates still stuck near historic lows, and macroeconomic and geopolitical uncertainties abounding, income investing is harder than ever.

U.S. CPI has been at multi-decade highs over the past several months and is actually accelerating even as long-term interest (GOVT) rates remain stuck in neutral:

Data by YCharts

What does this mean? It means that the forward return potential for investors is historically weak on a nominal basis thank to extremely low interest rates pulling forward returns and bloating S&P 500 (SPY) valuation multiples over the past decade:

Data by YCharts

This also manifests itself in income yields plummeting across the major indices (QQQ)(DIA), making life extremely difficult for income investors, especially retirees:

Data by YCharts

Even worse, however, with inflation soaring, real interest rates are deeply in the red, making life nearly impossible for income investors as the purchasing power of their passive income is getting eaten away rapidly.

Add to that the immense macroeconomic and geopolitical uncertainty being caused by the latest Omicron variant surge, China's and Russia's saber rattling in their respective regions, and ongoing supply chain headaches, and the risk-adjusted returns being offered investors right now are not enticing at all.

However, incredibly, there are still a few small windows of opportunity remaining. In this article, we will discuss one that not only offers incredible value, but is also defensive in nature and is resistant to inflation: energy midstream.

Energy Midstream Stocks Offer Incredible Value

First and foremost, energy midstream (AMLP) is quite likely the most undervalued sector in the market today. Take for example, blue-chip Magellan Midstream Partners (MMP) that boasts the highest returns on invested capital in the industry, 21 years of distribution growth, and a sector-best BBB+ credit rating. This clearly is not a case of a highly distressed, junk bond issuing company that is at a high risk of cutting its distribution, and yet, its distribution yield has more than doubled over the past 5 years to around 9% compared to the rest of the market which has seen its income yield plummet. Fellow income instruments like REITs (VNQ), utilities (XLU), and the Dividend Aristocrats (NOBL) have all seen their income yields fall substantially over the past half decade. Even triple net lease REITs like W. P. Carey (WPC) and Realty Income (O) - which are widely viewed to be at risk due to soaring inflation - have seen their yields fall over the past half decade:

Data by YCharts

Then, there is investment grade midstream business Energy Transfer (ET) that is trading at a paltry 7.5x EV/EBITDA multiple, over 2 full turns below its historical average despite interest rates plummeting over that period and the balance sheet reaching its strongest state in years:

This clearly indicates immense value in the space. The value looks even more compelling when you realize that the sector is actually one of the most inflation resistant in the economy as well.

Energy Midstream Stocks Are Inflation Resistant

While energy midstream has taken a beating over the past half decade due to incredible volatility in energy prices, fears about soaring ESG investment, corporate, political, and regulatory fervor, and excessive supply of midstream infrastructure after a massive buildout, there is a reason to be quite bullish moving forward: midstream is in ideal position to weather inflation.

First and foremost, the vast majority of pipeline contracts are indexed to inflation. For example, Enterprise Products Partners (EPD) recently said that nearly all of their revenue is indexed to inflation:

On inflation, I want to say over 90% of our revenues have some sort of escalation mechanism in there, which are benchmarked to various indices. So we feel like we have a pretty good protection from inflation.

Furthermore, real assets with exposure to inflation hedges like energy tend to thrive in high inflationary negative real interest rate environments like we see today:

Source: Bloomberg Intelligence

This should provide a double boost to midstream revenues by improving both their immediate contract values as well as improve the strength of their contracts by enriching their clients.

On top of all that, with so much of the infrastructure built out, midstream businesses are mostly seeing CapEx budgets plummet even as their cash flows are growing as the economy re-opens, new projects come online, and inflation soars. This means that the negative impact of inflation - rising cost of construction materials and labor - will not hurt midstream companies very much as most of their labor and material expenses have already been paid for and now the assets are in place and ready to benefit from inflation boosts to contracts. This should lead to ballooning free cash flow numbers and yields, leading to significant debt paydown, unit buybacks, and distribution growth. Plains All American Pipeline (PAA) is a classic example of this as it is not only slashing growth projects, but even selling non-core assets to generate massive amounts of free cash flow.

Energy Midstream Stocks Are Defensive In Nature

Last, but not least, the fixed-fee contract nature of midstream pipelines make them very defensive to economic, demand, and commodity price volatility. Two great examples of this are Enbridge (ENB) and Kinder Morgan (KMI).

97% of KMI's cash flow is structured as either take-or-pay, fee-based, or hedged, while 98% of ENB's cash flow is structured similarly. On top of that, the quality of their customers is also quite high with 76% of KMI's customers and 95% of ENB's customers being rated investment grade or equivalent.

Add to that the rising strength of midstream balance sheets, the ballooning amounts of free cash flow, and continued access to cheap long-term fixed rate debt from the bond market, and the safety of midstream businesses has never been better.

As a final point, existing midstream infrastructure enjoys a moat by virtue of the growing political and regulatory headwinds facing new pipeline projects. This means that well-located pipelines are increasingly irreplaceable and do not have to worry as much about increased competition for their services.

Investor Takeaway

While market sentiment is certainly terrible on the sector, energy midstream offers a compelling combination of value, inflation resistance, and defensiveness, enabling investors with long-term timelines and substantial patience a golden opportunity to buy deeply undervalued high-quality businesses.

Even better, these businesses all offer extremely attractive income yields that are not only safe, but are poised to grow meaningfully in the quarters and years to come. In fact, many are even buying back units aggressively right now and more are likely to follow in the coming quarters as CapEx projects continue to decline in the face of growing regulatory and political headwinds.

As a result, we plan to allocate an increasing percentage of our Core Portfolio at High Yield Investor towards this sector in 2022, which we expect to continue our massive market outperformance thus far.

HYI Core Portfolio	41.51%
Global X Super Dividend ETF (DIV)	31.48%
S&P 500 ETF (SPY)	31.81%

Click to enlarge

On top of that, our midstream investments combine to generate an ~8% income yield for our High Yield Portfolio, joining forces with nearly 25 other high conviction holdings to generate a portfolio weighted average yield of ~5.7% that is well-covered by cash flows and growing.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EPD, WPC, PAA, ET either through stock ownership, options, or other derivatives. 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.