Last Friday, I participated in an “Ask the Pros” roundtable forum. If you attended that you would know that in general terms right now, I have two main themes when it comes to energy investing; I said there that I like large and I like mid- and downstream. There is a third influence, too: The scarcity of yield.
Before we go any further, I should probably explain what I mean by those terms, and why those are so important when considering energy stocks.
What I Mean by Large
By “large” what I really mean is stable, and with a strong balance sheet. Those things, of course, are entirely relative when it comes to energy. No energy company is really “stable” given the volatility of oil and natural gas pricing, and the industry is capital intensive, making high leverage and debt levels the norm. Still, there are some firms that are better equipped than others to ride out a downturn. The risk of bankruptcy is real in some of the others, so quality matters.
What’s with All the Streams?
If you are new to the energy investing world, the terms upstream, midstream and downstream will mean nothing, so I should explain how they are used. Upstream companies are those involved in exploration and production (E&P). They are the ones that seek then extract crude.
Midstream operations are basically about transportation. It is the process of getting the crude oil from the well to the refinery or export terminal. That usually means pipeline operations, although tankers, both truck and rail, are also a part of that process.
“Downstream” refers to the areas of refining crude and distributing and selling its constituent components, most notably gasoline.
Why Midstream and Downstream?
The big, household name energy companies, such as Exxon Mobil (XOM), Chevron (CVX) and BP (BP), are integrated firms. They are involved in all three parts of the industry, which is one of the reasons they have survived so many ups and downs in oil.
While E&P operations do well in a rising market for obvious reasons, midstream and downstream companies often do better when pricing is uncertain or falling. For refiners, the lag between crude price changes and the price of the products derived from it means that their margins often increase when crude is falling. The “crack spread”, the difference between the price of crude and its refined products, usually increases in that kind of market.
The benefit to midstream operations is less obvious, but price fluctuations outside of a complete collapse such as we just saw have less of an impact on them than they do on E&P. That is in part because if the drop is down to supply rather than demand issues, the flow through pipelines remains steady at worst, and demand for finite pipeline capacity sometimes even increases as producers step up output in anticipation of lower prices.
Put all that together, and midstream and downstream stocks look set to rebound quicker than upstream as the U.S. reopens and demand increases.
The Search for Yield
There is one other theme that should be borne in mind when picking energy stocks right now… yield.
The Fed has made it clear that they have no intention of backing away from ultra-low interest rates anytime soon. The perception that they went too far the last time they tried that and slowed the economy dangerously at the end of 2018 makes it likely that, if anything, they will err in the other direction this time and leave rates too low for too long.
Nor is that just a U.S. phenomenon. It is true all over the developed world, and it creates a problem for a lot of fund managers. There is a lot of money in the system that is required to generate income rather than capital gains, and 0.7% on a 10-Year Treasury Note just doesn’t cut it.
Over the next few months, as (hopefully) things return to normal, we will see big money seeking yield, and energy, in particular, midstream companies, offer a possible solution. Many of them are structured as Limited Partnerships, meaning that they are required by law to pass most of their profits on to shareholders. Even those that aren’t usually offer good dividend returns as well… they must to be competitive.
When you put all that together, it makes sense to look for big mid-stream companies to invest in for the coming months. Two of the biggest are Kinder Morgan (KMI) and Enterprise Products Partners (EPD).
As you can see, both got hit hard as oil collapsed earlier this year. They have bounced to some extent, but still offer around a 50% upside potential to their January levels. What is different from other oil companies here though is that they could achieve those levels, even if crude doesn’t get back to its highs.
There are similarities therefore, but there are also differences.
KMIs dividend is currently lower at around 6.5% as compared to the roughly 9% from EPD, but it has more chance of staying that way. There is a chance of it being cut given the carnage in oil, but they do have the option of maintaining it if they think a recovery is imminent, and actually raised their payout for this year when they reported last month. EPD, as a Limited Partnership, will potentially see more variation in payout.
So, while it may look as if KMI, whose dividend represents a payout ratio of 172% versus 82% for EPD, is more likely to cut, that isn’t necessarily the case. There is, however, still a risk that one or both dividends are cut, and that should be understood.
Even with that risk in mind, as it stands, KMI and EPD push all the buttons. They are big enough to withstand the downturn, operate in the mid-stream segment that can recover even if the oil rally stalls, and they offer attractive yields in a low-yield environment. For all those reasons, buying both at current levels looks like a decent trade.