With the recent recovery in U.S. oil and gas prices, many energy stocks have soared to fairly valued levels, while U.S. midstream continues to lag the rest of the space and remains undervalued. Midstream tilts toward more value than growth, considering the lack of near-term growth for many, with high yields and substantial excess cash flow after distributions, dividends, and capital spending to devote to debt reduction and share and unit buybacks. Several U.S. midstream names--including Enterprise Products Partners (EPD), Plains All American Pipeline (PAA), and MPLX (MPLX)--have been repurchasing units already. Considering current price/fair value and the quality of the business, we’d highlight Cheniere Energy (LNG) as an idea worth considering.
We’ve yet to see a stronger midstream recovery for a few reasons, in our view.
Higher oil and gas prices benefit exploration and production companies more directly via near-term unhedged exposure and higher expected cash flows from future drilling activity. Midstream firms and partnerships generally hedge commodity exposure to fairly minimal levels, and higher oil and gas prices don’t provide much of a direct benefit.
Midstream oil and gas volumes thus tend to be more important than oil and gas prices, and with many U.S. producers pledging to hold volumes flat and live within cash flows (a good move for them), midstream companies aren’t necessarily seeing the same expected volume uplift in the near term that they would have in cycles past.
Aside from organic volume growth, growth capital spending on new pipeline projects and related assets is the key earnings driver. Without higher levels of drilling activity and increased volumes, there’s no need for new projects, limiting industry earnings growth. OPEC is holding production back from the market, creating an artificial supply gap that can be met quickly by OPEC barrels, resulting in more uncertainty around the shape of any U.S. production recovery.
Looking across our undervalued coverage, we see some similarities.
A good chunk of the midstream names (Enterprise Products Partners, Equitrans (ETRN), Plains All American Pipeline, Cheniere, Magellan Midstream Partners (MMP), Energy Transfer (ET), Kinder Morgan (KMI)) are not seeing a lot of growth in 2021 as a result of the business mix and location of their asset bases. The market is very short term focused and not considering the growth that will occur in 2022 and beyond as drilling activity begins to return and volumes increase across a larger spectrum of midstream assets. Cheniere is a good example, as its trains will not be fully complete until the end of 2022. Similarly, Equitrans is dealing with legal and permitting issues with regard to its Mountain Valley Pipeline, which should be in service in late 2021, though the risk of the pipeline slipping to 2022 is increasing, contributing to a substantial 2022 earnings boost.
In contrast, others such as Oneok (OKE) appear fairly valued because they are able to drive more substantial earnings growth in 2021 than their slower-growth peers. Oneok was able to wrap up a massive capital spending program relative to its size in 2020, and the earnings contributions from those projects are still flowing through.
What would help midstream going forward?
Higher oil and gas volumes and a resumption in new growth projects, or completion of existing under-construction efforts and seeing the resulting earnings contributions.
Stronger evidence of capital discipline among the U.S. midstream players, especially as most have substantial excess cash flows available after funding distributions and capital spending plans in 2021. This is a first for the industry. Thus, as stock prices for the space have been crushed over the past few years, we’d like to see more share and unit buybacks and debt reduction. There wasn’t a huge amount of cash available in 2020, as capital spending budgets were still coming down, so 2021 offers companies the first good opportunity to return large amounts of capital to shareholders via buybacks and/or debt reduction versus distribution and dividend increases. Kinder Morgan has already committed to $450 million in repurchases in 2021.
A stronger ESG narrative would also help. We recently looked over all our U.S. midstream names, and only Williams (WMB) has committed to any sort of forward-looking carbon emissions targets. Enterprise also said it would target 25% of internal power needs from renewable sources by 2025 but was at 17% in 2019. In contrast, U.S. E&Ps have been a bit better recently at least at committing to clearer and more defined carbon emissions intensity goals.
Private equity takeouts could continue to pick off higher-quality assets at the right valuations, in our view, but size and other constraints will prevent larger names from being acquired. Higher inflation would also benefit the space, given the linkage of many oil pipelines to inflation-linked tariff indexes. We don’t expect the same inflation benefit for gas pipelines, given the lack of inflation-linked contracts.
Downside exposure aside from company-specific risks and risks already highlighted would be linked to potential disappointment in the shape of the expected U.S. economic recovery in the second half of 2021 as well as U.S. midstream valuation multiple compression. Higher interest rates and inflation would also make current industry yields in the 7%-10% range less attractive.
Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s