Stock Strategist Industry Reports

Midstream Energy Offers Moats at a Discount

Stephen Ellis

The midstream oil and gas industry has long been one of Morningstar’s classic examples of an efficient scale moat source. Of the 25 midstream firms Morningstar covers, 19 have an economic moat, and 17 have an efficient scale moat source. An efficient scale market exists when a market of limited size is effectively and efficiently served by one firm or a small number of firms. Would-be competitors are discouraged from entering because doing so would drive market returns below the cost of capital. As the oil and gas pipeline industry is made up of numerous regional markets and further stratified by the quality and type of hydrocarbon transported between specific locations, it is clearly an efficient scale market.

Hydrocarbons are produced and consumed in different places and in different forms from how they come out of the ground. Midstream firms transport and process hydrocarbons. Once a transport route is established, there’s usually little need to build a competing route. Doing so would drive returns for both routes below the cost of capital. Thus, pipelines are generally moaty because they efficiently serve markets of limited size.

Stephen Ellis does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.