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.
Glaser: What do investors need to be focused on then when doing this analysis? Is it just a location of the pipeline? Is it management? What are some of the key things to look out for?
Coffina: Definitely the two factors that you mentioned are very important. So you want a management team that can adapt to the changing circumstances, that can deliver projects on time and on budget, which is also an issue for Boardwalk, where they had some cost overruns in some major projects. You definitely want them to be able to operate the assets reliably and safely. You want assets that are well-positioned, and often broad diversification helps both to create new investment opportunities and also to make it relatively safe that your cash flows will be maintained over time.
And another factor that's really important is the cost of capital. A lot of midstream investors are more yield-oriented. They might be tempted to seek out the highest-yielding midstream companies, or master limited partnerships, but that's often a challenge for the companies themselves that they have a high yield, often compounded by general partner incentive distribution rates. It can make it very hard to create value through incremental growth projects, either organic growth projects or acquisitions.
Glaser: Let's take a look at the Kinder Morgan family. They have been under some fire from a number of sources, including Barron's. Can you talk to us about what some of the challenges this company faces and how worried you are about it?
Coffina: Kinder does face some very real long-term challenges. This mostly is a result of management's relatively aggressive distribution, financing, and accounting policies. For example, a lot of the controversy has been focused on the way that they account for maintenance capital expenditures, and there is some spending in the oil-recovery segment, in particular, where they are not reserving any funds for maintenance capital expenditures, even though those funds are needed just to keep production flat. So it would be an example of a relatively aggressive accounting decision that management is making.
Also, Kinder tends to pay out a 100% of distributable cash flow to investors. There is a very little margin of safety if anything were to go wrong unexpectedly, in terms of excess distribution coverage, and Kinder also has a very high cost of capital. The limited partnerships are yielding more than 7% now. Once you add in the general partner's incentive distribution rights, you are talking about a cost of equity capital that's north of 13%, 14%, which makes it very difficult for Kinder to create value through organic growth projects or through acquisitions.
Glaser: What's your advice to someone who holds these shares now? Is it time to sell?
Coffina: We own Kinder Morgan Management in the Tortoise portfolio, but it's a very small position for us. I think Kinder has a relatively clear path toward mid-single-digit kind of distribution growth in the short to intermediate term, but then the picture gets cloudier beyond say 2018 or so. I am not in a rush to sell Kinder. I think I want to give management a little bit of benefit of the doubt given their track record and see if they can resolve some of these longer-term problems, which are really much more organizational in nature than they are anything to do with Kinder's economic moat.
So there are some outs for management. I think there are some things that they could do that would potentially alleviate some of these concerns, whether it be a very value-accretive acquisition, where they could use that to build up some excess distribution coverage. Maybe down the road, they can merge the general partner and the limited partnership, so they can merge El Paso Pipeline Partners into Kinder Morgan Management or Kinder Morgan Energy Partners.
I think there are some things that management can do, and I don’t think the situation is urgent like we need to rush out and sell. But it's definitely a company to have on your radar screen as having potential warning signs. There are definitely yellow, if not red flags out there. So, I think investors should proceed with caution.
Glaser: What are some names in this base that you are more interested in now?
Coffina: Getting back to the idea of management, the quality of the assets, and the cost of capital being important, a few names that look interesting right now would include Magellan Midstream Partners, and Enterprise Products Partners. These companies both acquired their general partners several years ago, which means that they are not subject to incentive distribution rights, and they have some of the lowest costs of capital in the industry.
These companies can do deals with their acquisitions or invest in organic growth projects that would be very value accretive for them but wouldn’t make any sense at all for Kinder, for example.
Also I think there is a tremendous investment opportunity in the oil sands in Canada and Canada's two big midstream companies being TransCanada and Enbridge both look potentially interesting. They have huge backlogs of organic growth projects, relatively safe business models, and very highly regulated returns, but that also protects returns on the downside as well as limiting it in on the upside. I'd say Magellan, Enterprise, Enbridge, and TransCanada all look potentially interesting.
Glaser: Matt, thanks so much for your thoughts on midstream today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser.
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