Note: This video is part of Morningstar's November 2015 Income Investing Week special report.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined by Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also the director of equity-income strategy here at Morningstar. He's going to give us an update on what's happening in midstream energy.
Josh, thanks for joining me.
Josh Peters: Good to be here, Jeremy. It's common topic these days.
Glaser: Yes, this has been obviously a popular topic for dividend investors and elsewhere.
Peters: Popular, painful, and not yet quite ready to go away and fade into the background, it seems.
Glaser: We have seen some earnings recently that have kind of brought it back to the forefront again. When you look at midstream earnings and you look at how these companies are coping with low energy prices now, what's being revealed to you?
Peters: Oh, boy--I really hate to use this cliché, but this is the tide going out, and we're discovering who has been swimming without proper attire. All of these midstream operators are really on a scale from utilitylike--which are the real toll-road operators that everybody likes to talk about but not everybody in midstream energy really is--to companies that are really no less volatile than the E&Ps who are their customers. If you're in the business of running pipes out to the wellhead and gathering gas or gathering crude oil, you may be charging fees per gallon or per thousand cubic feet of gas, but if there is no drilling, there is no well. If there is no well, there is no gas. If there is no gas, there is no fee. So, that can turn out to actually be a pretty tough business.
So, I like to think of it as the closer you are to the consumer, the more consistent the demand is going to be, and the more those fees and the volumes are going to be consistent. That's really where you're going to find the consistent cash flows that people have started to assume that every partnership out there could generate--that is not, in fact, turning out to be the case.Read Full Transcript
Glaser: So, when you look at these ones that are closest to the consumers, which ones do you think are still the best positioned today? Do any of them still look cheap?
Peters: They've come up a little bit off of the bottom, but Magellan Midstream Partners (MMP) is still my favorite. The majority of cash flows in that business are still delivering refined petroleum products. So, they have a pipeline that will run from, say, an oil refinery to the loading rack where some other company then picks up gasoline in a big tanker truck and brings it to your gas station. That's basically a utility, and it's even price-regulated like a utility--except they automatically get to raise prices in line with inflation plus a couple of percentage points as opposed to, say, a traditional electric or gas utility that's constrained by their capital investment and allowed rate of return. So, that makes for a really attractive asset that can continue to grow its cash flow even in tough times. And guess what--gas prices are low, so people drive more. Who'd have thought? And that's good for Magellan Midstream Partners. It gives them a natural hedge, in fact, for the piece of their business that is involved in carrying crude oil, which has been a great source of growth for them and which they've pursued very wisely, locking up a lot of volume under fixed contracts and making sure that they get paid back for those investments.
Spectra Energy Partners (SEP) runs a similar type of business--only in natural gas. They are gathering from the gatherers and processors and running that gas up to major markets in the Northeast or to power plants and chemical plants, all of which are going to be encouraged to buy more natural gas when the prices are low. It will displace other energy sources--mostly coal--in the case of power generation. Low energy prices are good for them, and yet its stock traded like it was just another one of the MLPs for a while. It actually experienced a pretty severe drop.
Now, in both cases, they are cheaper than they were earlier in the summer, and they are lower than they were a year ago; but they both raised their distributions--by a double-digit percentage in the case of Magellan. The yields have come up, so they are more lucrative to own. They still have good growth trajectories in place, yet they actually now have a very nice advantage relative to their struggling competitors in that their cost of capital is lower. They can afford to go out and make acquisitions, especially as distressed assets come on the market--or better yet, as distressed sellers put good assets on the market. They are in a position to actually expand faster as a result of this downturn. So, these are really the kinds of partnerships I think you wanted to own going into this downturn, and I found myself in the fortunate position that those were the names I owned coming into this downturn.
Glaser: Outside of those, are there any that could become cheap enough that dividend investors should be interested? Or would it have to pass that quality test before you look at valuation?
Peters: Those two plus Enterprise Products (EPD) pass that quality test. I'm very confident not just in the cash flows that they produce but also in that margin of safety. They've got some room for things to go wrong before their balance sheet is in trouble, before they have to contemplate cutting cash distributions. Right now, they are covering fully and then some, so I've got room for things to wrong. I've got room for me to be wrong or overly optimistic before my capital, my income is really at risk.
Now, if you flip that around and you look at Plains (PAA) or ONEOK (OKS), they are not covering their distributions fully at this point, and they are struggling to get back to full coverage. You don't know whether they will be able to do it or not. I think it's too early in this downturn to actually be able to stake the claim and say that the distribution is going to be safe, it's going to be maintained--and I can go ahead and buy this.
The yields are up in the 9% plus range right now, but I'm still not drawn in by that because that doesn't do you any good if those distributions get cut. And if they get cut, they're not going to get cut 5%--they'll get cut 50%. It will be substantial. The only precedent we really have for this was Boardwalk. When it really hit the bricks--which was early because it had a specific asset that was in real trouble--they cut their distribution 80%. And then they have the opportunity to reserve more cash flow for themselves to pay down debt and maybe start rebuilding their business. So, if we come to the point where we start seeing distribution cuts, I think they are going to be big and they are going to be painful. It's just too early to start going into some of the lower-quality names with more stretched finances--especially the ones that aren't fully covering their distributions. It isn't saying they're bargains. You might have to go through a very, very painful period before you see any sort of daylight with some of those names.
Glaser: Josh, thanks for the update on midstream today.
Peters: Thank you, too, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.