Reasons For Midstream Investors To Be Calm Amid Today's Stock Market Storm

Summary

• Oil and gas midstream stocks are not E&Ps, though they're trading as if they were.
• Oil macro conditions will remain positive for midstream above $70 per barrel.
• With shareholder value remaining stable or growing, midstream stocks are likely to see a swift recovery.
• Looking for a helping hand in the market? Members of HFI Research MLPs get exclusive ideas and guidance to navigate any climate. Learn More »

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A selloff like today’s can shake an investor’s confidence. For midstream investors, it shouldn’t.

For years we have embraced investing in high-quality income-producing midstream equities for the long term through thick and thin. We are confident in our strategy because the companies we invest in have sustainable cash flow in all but the harshest economic environments. When stock market conditions are good and their shares are flying high, they can return cash flow to shareholders through distributions. When market conditions turn tough and their shares drop lower, they can pivot toward accretive repurchases. Either way, these companies build shareholder value and earning power per share.

We believe strongly that there are good reasons to stay the course.

1. Midstream is not E&P

Exploration and production companies are price takers. They have no control over the prices that dictate their revenues. As a result, their value depends on oil and gas prices.

By contrast, midstream companies negotiate fixed fee-based contracts that depend on commodity volumes. An example is Magellan Midstream’s (MMP) system that distributes refined products throughout the U.S. heartland. As long as throughput volumes remain stable, MMP’s cash flow is stable. Management can allocate that cash flow in the manner that best suits shareholders, as it has done successfully for decades. With MMP—as with other public midstream operators—cash flow stability provides a direct means for management to build unitholder value under almost any conditions.

Our portfolio is packed with examples of midstream equities that exhibit underlying economics similar to MMP. During selloffs like today’s, equity owners have to keep in mind that in each case, management will channel today’s cash in the most advantageous way for them.

2. Macro is positive above $70 per barrel

Midstream gathering and processing (G&P) operators are indirectly exposed to commodity prices. They build value when their customers increase production. Because we expect U.S. production to grow as long as oil prices trade above $70 per barrel, oil prices would have to fall by another 33% before we lower our expectations for G&P growth. Remember, in midstream, it’s commodity volumes that matter. As long as commodity prices are supportive for U.S. volumes, the outlook for G&Ps is bright, regardless of short-term oil and gas price gyrations.

With the world in the midst of structural, multi-year energy shortages, a call on U.S. oil and gas production will have to be sustained. We believe the market will oblige by keeping prices healthy for U.S. production growth. Only a deep recession will push prices below $70. However, we’ve seen such a tepid supply response to high prices that the oil-price recovery is likely to be swift as soon as global demand rebounds.

With oil prices sustained at prices that incentivize U.S. production, our G&Ps can expand their operations. They can grow their cash flows, invest in new projects, and reward their long-term shareholders with increasing distributions and share repurchases.

Midstream investors should keep these fundamental points in mind when their stocks are trading lower. In doing so, they can make the conscious decision to ignore the silly market prices or use them to buy more.

3. Midstream stock prices will bounce back

Value wins in the end. A management team that builds value for shareholders exerts upward pressure on their company's share price over time. Ample and stable cash flows enable midstream management teams to do just that, which is why we're confident that investors who buy midstream stocks when they're cheap will be rewarded. As long as investors stick with high-quality companies operating high-returning assets with management teams allocating capital well for shareholders, we believe it is only a matter of time before stock prices recover.

We are confident in shareholder value creation because—pardon the phrase—this is not your father’s midstream industry. Today’s industry is more disciplined with regard to capital than it has ever been. It has avoided wasteful new projects. It has paid down debt at a rate never seen before in its history. And it has rewarded shareholders with record amounts of distribution hikes and share repurchases. In short, capital allocation on behalf of shareholders has become the name of the game.

Conclusion

Today’s selloff is occurring for various reasons unrelated to midstream fundamentals. Fundamentals remain well supported, with demand holding up and the supply outlook remaining challenged. The Biden administration is flailing in its attempts to rein in prices, but its efforts are ultimately bound to backfire. Export restrictions, price controls, tax holidays, and even public shaming—all are likely to support demand and/or constrain supply. Midstream shareholders can rest assured that they’re exempt from the short-term whims of commodity prices and that they can benefit by staying the course. The obvious conclusion is to follow the stable cash flow and buy high-quality midstream equities.

Disclosure: I/we have a beneficial long position in the shares of MMP 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.