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By Matthew Coffina, CFA | 03-14-2014 02:00 PM

4 Picks in Midstream Energy

Warning signals are evident among several MLPs, but tremendous investment opportunities still remain in the energy sector, says StockInvestor editor Matt Coffina.

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. It's been a rocky couple of weeks for the midstream energy sector. I'm here today with Matt Coffina. He's editor of Morningstar StockInvestor newsletter. He's going to tell us where he is still finding value in the sector and where he'd be much more cautious.

Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: First off, can you just tell us a little bit about what the midstream energy sector actually does?

Coffina: Sure. Midstream energy companies own the infrastructure that's necessary to move oil and gas from point A to point B. These would be things like pipeline, storage facilities, processing plants, terminals, and so on.

Glaser: This sounds like pretty a staid business. Why all of a sudden is there so much concern about some of these companies?

Coffina: Normally, it's a very steady business, and that's why investors like it. The thing is that a pipeline can stay in the ground and can last almost indefinitely. The concern is that there is not always going to be customers on either end of the pipeline.

North America is experiencing this huge energy boom, and a lot of the energy is coming from areas that didn't traditionally produce as much energy. For example, Pennsylvania's Marcellus shale and the oil sands in Alberta, Canada. This is creating a lot of opportunity for midstream companies in that they can invest in new projects and often earn attractive rates of return on those projects, but it's also creating challenges for other companies. Boardwalk Pipeline Partners is a prime example of this, where their existing infrastructure might not be in the best location.

In Boardwalk's case, their main assets were designed to bring gas up from the Gulf Coast to the Midwest, and those are much less relevant now with all the gas production occurring in the Marcellus shale. Companies certainly need to adapt to the current environment, and some companies that don't adapt could face some significant challenges.

Glaser: Boardwalk had that massive 80% cut to its distribution. Are you expecting to see similar cuts from other companies, or is it really that case-by-case basis?

Coffina: It's definitely case-by-case basis. I think the Boardwalk situation was unique in a lot of ways. One, they were not very diversified, so they are very reliant on these assets, again, bringing gas from the Gulf to the Midwest. They also are relatively highly leveraged and had core cash flow coverage and core distribution coverage for quite a while. Management has also not been very clear with investors about its plans, about its outlook, and has really failed to adapt to the changing environment.

Partly it's Boardwalk’s assets that are to blame, so other companies like Kinder Morgan, for example, that also have assets that are somewhat similar to Boardwalk's, their assets extend into the Marcellus shale, which has enabled them to participate in a lot of these incremental investment opportunities. [However,] Boardwalk's pipelines didn’t quite make it into the Marcellus shale, so they had all the headwinds but without the tailwinds of having incremental investment opportunities.

I think Boardwalk's situation is somewhat unique, but it's certainly important for midstream investors not to take for granted that this is a very steady, stable business and always will be and really to pick and choose your spots.

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