Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
The midstream energy sector has been under a lot of pressure recently. I am here with Josh Peters, editor of Morningstar's DividendInvestor newsletter and also our director of equity income strategy, to see if this has opened up any opportunities for dividend investors.
Josh, thanks for joining me.
Josh Peters: Good to be here, Jeremy.
Glaser: Let's talk about some of these industry pressures and why the share prices have been falling. What are some of the issues that are facing midstream energy? Weren't these supposed to be "toll booth" businesses and that the price of oil wasn't going to have such a big impact?
Peters: I think the midstream MLPs can be very good businesses, but they have developed a tendency over the last couple of years for the virtues to be oversold to investors. Certainly the promoters of the industry on Wall Street had a vested interest in describing these as toll roads that were going to throw off lots cash flow and pay these big distributions no matter what happens to energy prices. That really was never true, because the simplest way to think about it is that the midstream energy companies--pipelines, storage, gathering and processing, these kinds of activities--their clients effectively are the producers of oil and gas as well as the consumers.
Well, the producers and the consumers at each end of the pipeline are affected by the price of the commodities flowing through it. So how can you expect the literally middle-of-the-stream midstream businesses not to be affected too? Even as the S&P energy sector has been under a tremendous amount of pressure since the end of the summer of 2014 on the lower oil price environment, midstream MLPs, using the Alerian MLP Index, is down by roughly the same amount--depending on the day, it may be down even a little bit more. I think that shocked a lot of people, but it's got something to do with the group just having been oversold and perhaps partnerships getting access to capital that ought not to have happened under a more sane environment for the industry.
Glaser: We've had this pullback. Has that created a wealth of opportunities? Are there a lot of options if you wanted to buy midstream today?
Peters: I think it is not too early to be very selectively greedy. As we've moved into this period I only owned two names in midstream energy. And it was a smaller piece of my portfolio than it had been since inception back in 2005. I'd owned more even until early 2014, and I looked at these businesses and I said, there is just not the margin of safety here for any kind of downturn if they are paying out 100 cents on the dollar of their distributable cash flow, which in a lot of cases is sort of an enhanced interpretation of long-term earnings, to put it mildly.
So I sold my exposure down to where I held only Magellan Midstream and Spectra Energy Partners, which are very strong businesses from an operational and cash-flow standpoint and also providing the requisite levels of financial strength to see to it that they can continue to pay and, in fact, raise their distributions even through a downturn.
They've held up better than the average, which reflects that the market understands that these are stronger businesses, but they have gotten cheaper. I like them both right here. Magellan, depending on the day, is my largest holding. It used to be my largest holding by some margin, but it's come in little bit. And those are our two names that I would be comfortable adding to at these prices.
A few weeks ago I did buy a third, which is really the only other name in midstream energy that I think has the level of financial conservatism combined with the asset quality where you could say what I'm buying here is a long-term high-quality investment--that's Enterprise Products. Even at that, I took a very small position and figured I'd let market volatility perhaps serve up some opportunities to expand that stake over time.
But you look out farther and you see a lot of partnerships that are now not covering their distributions--in some cases their parent companies are not covering their c-corp dividends--from ongoing cash flow. That means that they are borrowing to pay distributions, and they are probably borrowing money on top of that in order to fund growth projects. Those growth projects may or may not turn out to be needed by the industry as they come online.
So you have to think, where is this partnership in terms of the stream, the chain between the wellhead and the burner tip? I think in general the closer you are to the consumer the more reliable your volumes are going to be, and hopefully you'll have that nice fee-based stream of cash flow. The closer you are to a drilling base, and if you are gathering and processing, if they are not drilling, then you shrink. That's just a tough business. And we haven't seen this sort of cycle in the industry, in its sort of MLP era, that we're seeing right now.
I'm expecting that, unless you see a dramatic, sustained turnaround in the price for crude oil and natural gas, there are going to be distribution and dividend cuts. That's going to mean volatility, even for the very high-quality, very financially strong companies, like the ones I own. But to be buying them at these prices, leave yourself some firepower to maybe pick up even more at still lower prices, if that happens. And if things snap back, well you've already got a decent stake in some very good companies that are positioned to thrive and continue to grow their distributions, even in a less attractive environment than we've had over the last couple of years.
Glaser: In the energy space, you also own Chevron. How have low oil prices been affecting them? Are you worried about dividend cuts from Chevron?
Peters: Well, the stock price has gotten totally clobbered. And by some measures, depending on how you want to define their peer group, Chevron has actually fared worse than an Exxon or a Shell. I think this reflects the fact that they made a very large bet--and I think it was a prudent one at the time--to expand their production. They'd had a lot of luck with the drill bit and really expanded their resource base, and then they followed that up with tens of billions of dollars of commitments for capital spending in order to build out that resource base and turn it into production, which, in turn, turns into cash flow.
Other oil companies have been able to slash their capital outlays much quicker and have tried to prop up free cash flow that way. But Chevron is still at the tail end, where they need to bring these projects--some of them are huge--into service, and they still have to spend the money, even as cash flow has dropped.
So, ordinarily over the last couple of years, they have been raising their dividend in the second quarter of the year. They didn't do that this year. They have, however, managed to preserve a lot of financial flexibility. They didn't pile on a lot of debt in order to finance share buybacks when times were good. They actually let their cash balance accumulate. They are not in a position where they need to cut the dividend immediately, and the farther out you look, if you start thinking that oil is going to go to $20 a barrel and stay there, well then you have to wonder if even Exxon cuts its dividend, right? But do we have over a three-, four-, five- or 10-year period prices that low? That's unrealistic given what we think the marginal cost of extracting a barrel of oil is.
And one of the nice things that will eventually intervene and help the global oil price is that you lose 3%, 4%, 5% of global production every year to depletion. So if you are not drilling more and expanding the resource base to replace the stuff that's been pumped, you're going to run off supply and then you are going to have prices respond to less supply for a given level of demand. I've heard it said that the cure for low prices is low prices. We do think that something in the high $30s for West Texas and mid-$40s for Brent is too low on a long-term basis.
Chevron has made it very clear that, come 2017--I know, still an impossible 16 months away--but come 2017, they are going to have a lot more flexibility to scale down their capital investment and improve free cash flow, and they should be able, at that point, to have restored full coverage of the dividend.
So we're going to go through a period here where the numbers are going to look kind of bad, but the way Chevron managed its balance sheet very conservatively in the years leading up to this downturn has given them plenty of flexibility to maneuver through a couple of quarters where they won't have the free cash flow to pay the dividend directly.
Glaser: Josh, thanks for the update today.
Peters: Thank you, Jeremy.
Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.