How midstream firms are staying afloat with $40 oil
The sustained collapse in oil prices over the past year has caught the entire energy sector off guard. Projected lower commodity prices for 2016 are obviously a negative catalyst for the industry. But there is one group within the energy sector that is still faring relatively well, even while commodity prices are crashing. These are the so-called midstream firms, which include companies that own and operate energy infrastructure assets like pipelines and storage terminals (infrastructure that will be required for decades and decades to come).
As a result, midstream firms like Kinder Morgan, Inc. (NYSE: KMI) and Enterprise Products Partners LP (NYSE: EPD) have continued to increase distributions this year, even though oil prices recently fell beneath $40 per barrel. Here’s how midstream companies have performed relatively well in comparison to the rest of the oil sector.
Midstream Business Model Provides Protection
Kinder Morgan, together with its various subsidiaries, is the third largest energy company in the United States, with an enterprise value that exceeds $100 billion. It owns and operates 84,000 miles of pipelines and 165 terminals, making it the largest midstream company in the United States. For its part, Enterprise Products’ assets include approximately 49,000 miles of pipelines, 225 million barrels of storage capacity for natural gas liquids, petrochemicals, refined products and crude oil; and 14 billion cubic feet of natural gas storage capacity.
Investors should think about midstream companies as similar to toll roads. Just as toll roads collect tolls from cars, midstream entities collect fees for the materials being transported through the pipelines and storage terminals. In this way, midstream companies are not highly reliant on a supportive commodity price; rather, cash flow is based on volumes. As demand for energy infrastructure continues to strengthen in the United States, cash flow has largely remained intact.
Over the first nine months of 2015, Kinder Morgan’s distributable cash flow, or DCF, is up 22 percent year over year. The biggest contributor to this is the company’s products pipelines and terminals businesses. Last quarter, the products pipelines and terminals segments grew earnings before depreciation and other items by 29 percent and 6 percent, respectively. Growth in these segments helped offset a 22 percent decline in earnings before depreciation and other items in Kinder Morgan’s carbon dioxide business, which does suffer from falling commodity prices. Overall, Kinder Morgan generated $228 million of DCF in excess of its dividend payments through the first nine months of the year. This is why the company can continue growing its dividend.
Enterprise Products reported record natural gas liquids, crude oil, petro-chemical, and refined products transportation last quarter. Crude oil volumes rose 13 percent, while volumes of refined products and petro-chemicals rose 9 percent. This helped distributable cash flow excluding asset sales grow by 5 percent last quarter, year over year. That easily covered Enterprise Products' distribution last quarter by 1.3 times, which implies sufficient distribution coverage.
This has allowed Kinder Morgan and Enterprise Products to continue increasing distributions, even in a very difficult operating climate. Kinder Morgan recently increased its quarterly dividend to $0.51 per share, a 16 percent year-over-year increase. Meanwhile, Enterprise Products has raised its distribution for 45 consecutive quarters.
Environmental Scores for the Midstream Group are a Concern
Investors should note that, like many energy companies, midstream firms receive mixed grades for their environmental impacts. The Carbon Disclosure Project, or CDP, seeks to change the way the business world responds to the threat of climate change, by demanding greater environmental reporting, while promoting the responsible use of natural resources. CDP has brought together a variety of stakeholders including shareholders, customers, and governments to incentivize companies to disclose their environmental data. CDP then issues companies a score and grade depending on the results.
Unfortunately, Kinder Morgan declined to submit reports on water and climate change in each of the past three years. Likewise, Enterprise Products did not submit responses on climate change in 2015, 2014, and 2013. This clouds the view of Kinder Morgan and Enterprise Products from an environmental standpoint.
Negative environmental effects of building new pipelines were the primary reason why the Obama administration recently rejected the Keystone Pipeline XL project. This decision was consistent with the stand that the United States had become a leading voice on the issue of climate change. Investors should be aware of the prospect of increased public and regulatory scrutiny going forward as a result, and watch carefully how the midstream industry positions itself. The result may present either a threat or opportunity for assets critical to an efficient energy economy.
The price of oil has declined substantially in the United States over the past year, due largely to a global supply glut. However, demand has remained fairly resilient, requiring volumes to still flow through midstream assets. This is why midstream companies continue to generate cash flow, and their backlogs present plenty of future growth opportunities. To that end, Kinder Morgan’s backlog of future growth projects is now $23.1 billion, which should help generate higher cash flow in future quarters.
While the integrated and upstream companies suffer deteriorating earnings, the midstream firms continue to grow. Their high dividends are well-secured with underlying cash flow. For income investors searching for high yields in the energy sector, the midstream companies are a good place to look.
Companies to Watch
Magellan Midstream Partners (NYSE: MMP) another high-quality midstream operator. Magellan’s large crude oil business grew operating profit by 45 percent last quarter, year over year
Disclosure: The author is long KMI
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.