How Midstream Investors Can Best Navigate This Historic Oil Crash (2024)

This article was coproduced with Dividend Sensei.

Hard assets like REITs and midstream infrastructure have traditionally generated generous, safe and growing income, and solid long-term total returns.

However, as seen with black swan events like the financial crisis – when 87% of REITs had to cut or suspend their dividends – or the longest midstream bear market in history, which was a combination of the biggest bubble in industry history and several major oil crashes, safely navigating the high-yield waters can be challenging.

(Source: Reuters)

March 9, 2020, will likely be remembered as "Black Monday" for the energy industry. Analyst firm Raymond James even wrote of it:

“Monday will go down as one of the bleakest market days in the history of the energy sector... Was this capitulation day? It certainly feels like it... it is hard to imagine how much worse sentiment can get.”

That’s the bad news. The good news is that we're here to help you determine the best way to potentially profit from it all. Suffice it to say that we’re looking at some of the most intense opportunities ever available in the midstream industry.

To explain that, let’s dive into three of the most important facts anyone interested in midstreams needs to know.

Fact 1: Quality Midstreams Are the Most Undervalued They’ve Ever Been

(Sources: F.A.S.T Graphs, FactSet Research)

Historic Opportunity for Safe Yield for Brave Income Investors

(Source: YCharts)

We're absolutely not interested in chasing yield, or recommending or owning dangerous dividend stocks of any kind. Instead, we want names we're confident can maintain and likely grow their payouts over time – including through oil crashes and future recessions.

For instance, some midstreams were yielding 30%-60% on March 9. But we ignored those completely since they were small caps with heavy single-customer concentration.

Others however? We know they’re in the doghouse at the moment, but that just means they’re very temptingly priced. Some quality names are down more than 50% this year alone.

(Source: YCharts)

To be sure, we’re not saying there’s no good reason for their current out-of-favor positions. There are important risk factors facing the industry over the next year or two.

And they’re definitely worth talking about.

Fact 2: The Current Oil Crisis Is Likely to Last 12-24 Months

On Friday, March 6, Russia declared it wouldn’t back Saudi Arabia's plan to cut another 1.5 million barrels per day (bpd) on top of the 2.1 million bpd already in effect through April 1.

In response, Saudi Arabia declared a price war the very next day, slashing its crude prices and vowing to raise production from 9.7 million bpd to more than 10 million.

That’s why, when Monday came, the markets behaved the way they did. Because, in a case of classic bad timing, the global economy is expected to experience its first year of negative oil demand growth since 2009.

And that’s a combination investors didn’t know how to handle any other way but to sell.

Then Tuesday came and, with it, the news that Saudi Arabia was targeting 12.3 million bpd production – which is slightly beyond its 12 million full capacity.

Russia responded with reported plans to increase production 200,000-300,000 bpd in the short term and potentially 500,000 in the long term.

On Wednesday, Saudi Arabia retorted that it might eventually go to 13 million bpd. Though that would require tapping its emergency production reserves, which it can’t do for long.

The UAE, OPEC's third-biggest producer, joined the fray by increasing its own production from 3 million to 4 million bpd.

Add to that COVID-19, or the coronavirus, and you’ve got a recipe for disaster.

The Good News and Bad News About Global Growth

Back in December, OPEC estimated that 2020's global oil demand would rise by 1.1 million bpd. That forecast was cut by 1 million – so far.

In its latest “Monthly Oil Market Report,” it wrote:

“The tremendous impact that the COVID-19 outbreak had so far on economic growth has significantly impacted oil demand growth in 1Q20 and therefore led to a downward revision to show less than 0.1 mb/d growth for the entire year 2020.”

On the plus side, the International Monetary Fund expects global growth to spring back sharply next year to 3.4%. In which case, when the COVID-19 pandemic panic finally ends, oil demand is likely to soar.

Until then though, the world is going to be awash in excess crude.

Also unfortunate is how Russia has about $560 billion in reserves. So it’s prepared for a long fight. And Nick Cunningham over at OilPrice.com writes that Russia “can withstand the price war at $25 to $30 per barrel for six to 10 years. Neither side appears willing to budge."

Notably though, the Saudis have about $500 billion in currency reserves. According to the IMF, they need oil at $87 to balance their budget.

Russia needs just $42.

In response, the U.S. shale industry is racing to slash production spending. Some companies already have declared 32% capital expenditure cuts to survive this price war, which most industry experts think could last for one to two years.

As Charles Meade of Johnson Rice & Co. noted: “Not one company in our coverage can keep production flat for more than a few months while spending within cash flow at $35 WTI.”

So the bad news? It’s that this oil crisis is going to bankrupt more leveraged and lower-quality oil companies. And there’s really nothing to be done about it.

What to Expect From the Still-Developing Status Quo

(Source: Michael Boyd, Energy Income Authority)

The stronger names – those with low leverage and strong credit ratings – are likely to buy up bankrupt companies for pennies on the dollar. But the production from those oh-so-cheap assets will still need midstream infrastructure to get to market.

Otherwise, there won’t be any cash flow. Which, obviously, is a problem.

How this will all play out is left to be seen, of course. But memories of non-self-funding midstreams cutting payouts during the last great oil crash are still fresh in many investors’ minds.

If that’s where your head is, it’s understandable. Even so, let's look at the most important way income investors can potentially profit from the best deals in midstream history ever.

And without significant risk of payout cuts or permanent loss of capital.

Fact 3: The Strongest and Safest Midstream Names Are Where It’s At

In all, we have 12 names listed in the graphic below. And we chose them because they’re all:

• Self-funding business models with 0% reliance on equity to fund growth plans
• Investment-grade balance sheets
• Incentive distribution rights (IDR)-free.

They also have:

• Above-average or better safety
• Low and falling debt/EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios
• Low costs of capital and strong access to bond markets
• Highly diversified cash flow streams (i.e., they’re not small MLPs with single-customer concentration)
• High coverage ratios, with most featuring 1.5 or more.

And those kinds of companies actually did quite well during the 2014-2016 oil crash. Most saw stable or even rising cash flows, as shown below.

(Source: YCharts)

When it comes to Energy Transfer L.P. in particular, its fundamentals are far stronger today.

(Source: Daniel Thurecht)

As shown above, it has a coverage ratio of 1.9. And leverage has fallen from over 6 to 4.5, with five or less being safe and 4.5 being very safe.

Furthermore, it plans to reduce growth spending next year so much that its projected $3 billion in post distribution (retained) cash flow will be able to cover all capex spending.

In other words, free cash flow self funding should cause leverage to steadily decline further over time, from its already safe levels.

Several other midstreams have announced similar plans, such as:

• MPLX L.P.
• The Williams Companies Inc.
• Enterprise Products Partners L.P.

That last company might buy back stock and fund growth 50/50 with retained cash and debt.

A Morningstar Memo

In terms of who’s most exposed to the oil crash, gas producers might be in a better position these days. As Morningstar explains:

“We think gas-oriented midstream firms remain the right defensive play in this market, with oil prices collapsing in the wake of the OPEC+ breakdown. We favor firms such as Energy Transfer, Kinder Morgan, Cheniere, and Williams.

“In particular, we expect Energy Transfer, Kinder Morgan, and Cheniere to generate significant excess cash after investor payouts and capital spending plans, providing them with substantial financial flexibility. Fundamentally, retail gas demand remains stable, and utilities will need midstream services to meet demand. Energy Transfer’s and Kinder Morgan’s assets are the backbone of the U.S. gas transportation system. Cheniere's cash flow is supported by long-term LNG contracts that have to be paid even if customers do not lift cargoes.

“However, even firms with gas exposure face challenges in the near to medium term. Falling oil prices will put substantial near-term pressure on Permian producers to curtail oil production. With Permian oil volumes at risk, a substantial decline in associated gas production from the Permian is likely, as Permian oil producers are indifferent to gas prices because they do not drive well economics."

To be clear: It's not clear sailing for anyone in the industry right now. That’s why we're watching each company very closely for early signs of distress, such as:

• Dips in cash flow consensus forecasts
• S&P credit ratings
• Dividend cuts

However, given the very high insider buying in top-quality, safe midstream stocks in recent days, we're not overly concerned. Oil producers and oil service firms could be a very different story.

But we’re willing to “take the chance” on the other side when it comes to midstream.

We Like What They’re Seeing

(Source: Openinsider)

For its part, EPD management already owns more than $12 billion worth of its stock. That allows them to collect $1.3 billion per year in distributions.

Yet, as shown above, they’ve still been buying aggressively, both before and after Monday.

The same is true of Energy Transfer. Management has been buying stock by the tens of millions during the correction.

(Source: Openinsider)

ET CEO and founder Kelcy Warren alone owns 260 million units, which pay him $317 million per year. His salary is $1, and he literally lives off the distributions.

Then there’s WMB…

(Source: Openinsider)

KMI…

(Source: Openinsider)

PAGP…

(Source: Openinsider)

And OKE…

(Source: Openinsider)

Truly, the best thing income investors can do in any bear market is to remain calm, employ a proper risk-management strategy, and be opportunistic concerning top-quality companies whose valuations indicate a highly favorable reward/risk ratio.

Here are some average safety stats to look for in that regard:

• P/cash flow: 5.5
• Cash flow yield: 18.2%
• Cash flow yield risk premium: 18.2%-0.7% 10-year yield = 17.5%
• Cash flow risk premium for S&P 500 since 2000: 3.7%
• Implied long-term growth rate: -6% compound annual growth rate
• Actual average analyst long-term growth consensus: 5.1%.

Meanwhile, their average reward/risk ratio is 4.7. And their recommended reward/risk ratio from Graham, Dodd, and Carnevale is 1.6.

In fact, let's look at our list’s fundamentals next.

Digging Down Deep

The average fundamental stats on these midstreams are:

• Quality: 9.1/11 blue-chip vs. 9.7 for the average dividend aristocrat and 7.0 for the average S&P 500 company
• Dividend safety: 4.3/5 (above-average) vs. 4.7 for aristocrat and 3.0 for the S&P 500
• Yield: 10.9% vs. 2.1% for the S&P 500 and 2.5% for most dividend growth ETFs
• Valuation: 40% undervalued vs. fairly valued for the S&P 500
• Dividend growth streak: 10.2 years, which makes them dividend achievers
• 5-year dividend growth rate: 4.5% CAGR
• Analyst long-term growth consensus: 5.1% CAGR vs.6.3% for the S&P since 2000
• Forward P/E ratio: 5.5 vs. 10.3 for the S&P 500 at its bottom on March 9, 2009
• PEG ratio: 1.08 vs. 1.85 for the S&P 500
• Credit rating: BBB, which is investment grade
• Annual volatility: 27.4% vs. 15.3% for the S&P 500 and 22% for aristocrats
• Market cap: $25 billion vs. $135 billion for the S&P 500
• 5-year total return potential: 26.8% CAGR with a 25% margin of error.

Summed up, these are not yield/value traps with declining cash flows and weak balance sheets. They’re collectively blue-chip midstream giants with BBB credit ratings that are priced for -6% CAGR growth, but expected to grow about 5%.

If they grow as expected and merely return to their average fair market values since the midstream bear market began, then up to 27% CAGR long-term returns are possible.

At last check, these stocks were so undervalued that – according to the Graham/Dodd fair value formula – as long as they achieve 0% growth over time, investors literally can't lose money. Consider the following five-year total return equation:

10.9% yield + 0% growth + 7.0% valuation boost = 17.9% CAGR (13% to 23% CAGR with 25% margin of error)

An Honest Evaluation

Again, this historic crash in midstreams is NOT based on fundamentals. It's based on fear over what could happen to fundamentals in the future.

Objectively though, our list’s finances have never been healthier. Which is likely why insiders are buying so furiously.

Panic is not a good investing plan, especially concerning what Chuck Carnevale calls "the buying opportunities of a lifetime – as long as the business models don't completely implode."

Or, to quote Vitaliy Katsenelson, a classic Ben Graham value investor:

“The prices you see on your screen today are the transitory manic depressive opinions of the often mentally unstable Mr. Market. (If I have offended Mr. Market, my apologies).

“Mr. Market did not carefully value your companies today and decided that they are now worth less. No, he woke up in a grumpy mood and indiscriminately marked them down as if they were overripe bananas at the grocery store. (You cannot have enough metaphors here.)

The stock prices on your screen say nothing about what these companies are worth. Nothing at all.”

He added,

“I promise you one thing: The value of your companies doesn’t change 8% a day, day after day."

We don’t know about you, but that evaluation sounds profitable to us.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.