How to Invest in Midstreamers

"Toll collectors for big oil" doesn't sound like the sexiest industry, but these companies tend to be cash-generating machines for shareholders.

In this week's episode of Industry Focus: Energy, host Michael Douglass and Motley Fool contributor Jason Hall dive into midstreamers and how to invest in them. Get the highlights from five of the biggest midstreamers' earnings reports and how the companies have set themselves up for the long term, how exactly midstreamers make their money, what risks and metrics investors will want to watch going forward, which of these five is the best bet and for whom, what you need to know about taxes, and much more.

A full transcript follows the video.

This video was recorded on Aug. 9, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Thursday, August 9th, and we're talking midstreamer earnings. I'm your host, Michael Douglass, and I'm joined by Jason Hall. Folks, we heard from a number of you, when I said offhand to Jason, "Maybe we should cover midstreamer earnings," a lot of people wrote in and said "Yes, please." So, we are here and we are excited to talk about it. But first, for those who need a refresher, let's talk about what a midstreamer is. Jason?

Jason Hall: The oil and gas industry is divided up into these different segments that start with exploration and production, then you have to move the product, and then you refine the product, and then you sell it. Midstream is a combination of the stuff that happens in the middle. It's the companies that gather the oil and natural gas and natural gas liquids, then they stick it in pipelines and move it to wherever it's going to go. They generally also operate the storage facilities where it sits in storage before it gets sent to the refiner to get refined, or before the refined product goes to the pump at the gas station where you eventually consume the product. The midstreamers are the ones in the middle. 

In terms of general investment thesis, these are usually cash flow machines, they're good opportunities for dividend investors because they generally sign long-term contracts to move product. They have fixed amounts of money that they're going to get. Generally, they should be a little less exposed to energy commodity prices because they're tollways. That's how they're sometimes described, because they take a fee to move or store a product. It's usually not related to how much that product costs at any given time.

Douglass: I'll actually say, it feels like all the time they're referred to as toll roads or toll booths or something that evokes this idea of, to pass, you must pay money. They can be really attractive businesses for that reason. We're going to talk about five of them. 

Let's start with Magellan Midstream Partners (MMP), ticker MMP. First thing to note here, distributable cash flow up 7% year over year. You notice I'm talking about cash flow. I'm not talking about earnings, I'm not talking about revenue. That's because cash is king in this particular segment of the industry.

Magellan has some good things coming up. They're planning to bump their tariffs on refined product pipelines and services by a little over 4% at the beginning of the second half of this year. Some good things to see, if you're thinking about on just, making what they currently have more profitable for them. 

On last week's episode, you heard us talking a fair amount about the Permian Basin. Well, midstreamers certainly have lots of potential areas to benefit off of Permian, particularly because, as we noted in last week's episode, there isn't currently enough infrastructure to get all of that oil out.

Hall: There ain't enough pipelines.

Douglass: Exactly. Magellan has a West Texas refined product pipeline that they're planning to expand to almost double, to 175,000 barrels a day. That's a Permian play. Not surprisingly, that's going to be a theme we're going to hear throughout midstreamers, because it's having a really big impact across this entire industry.

Hall: The Permian is definitely getting most of the heat and light, so to speak. But it's not the only one. North America is a serious growth place for midstream right now because of shale. The Permian is the hot place in shale right now that's getting a ton of new investment, but for years, there's been lots of investment in other places that are remote and not connected to pipelines. These things take years to build and they cost billions of dollars. So, there's a lot of growth happening in other places, too.

Douglass: That's one of the other key things to look at with the midstreamers -- what they're planning to do with their cash, what that construction pipeline looks like. For Magellan, as an example, historically, they have grown their distribution by 12% annually since their IPO. They're planning to slow it down to between 5-8%, specifically so they can really double down on some of these construction projects that they think are going to be really attractive and accretive in the coming years and reduce their reliance on things like share issuance. So, a lot of good things to see out of Magellan.

Hall: Magellan and the one we're going to talk about next, Enterprise Products Partners (EPD -0.41%), they both have been very good historically, in terms of capital allocation and not just counting on debt or selling stock to pay for capital projects. They've done a pretty good job of retaining some of their cash flows for growth. There may have been other midstreamers that paid higher yields, but in terms of being able to grow the dividend, grow the cash flows, Magellan is one that I like. This quarter is another demonstration of that.

Douglass: Yes, exactly. Speaking of Enterprise Products Partners, that's an excellent transition. Let's go ahead and hop on over, that's Enterprise Products Partners, ticker EPD. Distributable cash flow up 36%. Wow! Big gains in their natural gas pipelines and services. A lot of that is because, of course, the results of some new openings, including, not shocking, a natural gas processing facility in the Permian. [laughs] It's going to be a thing we keep talking about.

Hall: It is. One of the things that Enterprise Product Partners, I don't want to say they specialize in it, but something they do a lot of is NGLs, natural gas liquids. If you think about, whether you're drilling for oil or natural gas, there are other things that come up like isobutane, propane. You won't find someone drilling a propane well, because they don't exist. All these other products, they have separate values, and they have to be separated out. So, by having specialties take those take those NGLs and separate them out, so the producers or refiners can extract value, Enterprise Products Partners has done a really good job of leveraging that service that they offer.

Douglass: Yes. Also, like Magellan, they are slowing down the distribution growth, specifically so they can focus on funding that project backlog. Theirs is $5.2 billion. There's a lot of good stuff incoming for Enterprise Products Partners in the incoming several years, most likely.

Let's turn to Enbridge (ENB 1.68%), which is a little bit more complicated of a story. That's ticker symbol ENB. Enbridge is focused on ingesting Spectra Energy, a transaction that they closed in February 2017. Now, they are in the midst of attempting to acquire the remaining 25% of Spectra Energy Partners (SEP) that they don't already own. Of course, they want to reduce their leverage at the same time. There are a lot of different moving parts here with this company.

Hall: Enbridge, of all the midstreamers we're going to talk about, is certainly the one that's the most complex. It's a Canadian company, so they report earnings in Canadian dollars. They report pretty much all of their financial metrics in Canadian dollars. So, there's some translation that goes there, effects the actual U.S. dollar value of the dividend a little bit. 

Also, it has its fingers in lots of other subsidiaries that are publicly traded. With Spectra and Spectra Energy Partners, as Michael was talking about, it's in the process of doing a lot of consolidation. It can be a little more complex. We'll focus mainly on the business stuff. 

If you look at one thing that's going on, one of their older pipelines is pretty important, it's the Line III pipeline. This pipeline has lost a lot of its capacity over the years. They're working to get approval from regulators to essentially replace it. They got approval in late June. It was kind of a best-case scenario. There was some concern it might be rejected, but that was pretty low risk. The biggest concerns were, they were going to force Enbridge to spend a lot more money and route it around certain things that would add significantly to the cost. There were only some minor concessions the company had to agree to, removing some older pipelines that property owners requested. 

It's going to be able to more than double its current capacity back up to around 760,000 barrels a day. The good news is, it's made a lot of progress. In the next couple of years, it should be able to start generating a significant increase in cash flow from that. One of its older pipelines is going to be one of its newer, better pipelines.

Douglass: Right, how the old becomes new. Additionally, Enbridge has reportedly $20-35 billion Canadian dollars of projects under consideration. One thing we're going to want to see moving forward is what they will commit to within that, and actually build out a formal pipeline once they've ingested, figured out what they're doing with these other assets that they have either recently acquired or are in the midst of acquiring now.

Hall: I think, as far as what they've generally confirmed they're going to spend, it's well-known through 2020, they're going to spend around $22 billion or so on capital projects. As you see, there's another nearly $15 billion in projects that they're considering that we don't know what's going to happen to. That's a lot of potential growth.

Douglass: Absolutely! Jason, let's turn to ONEOK (OKE 0.53%), ticker OKE. Distributable cash flow up 37% on 30% adjusted EBITDA growth. They've also reduced their dividend coverage ratio a little bit. A lot of strong growth there, too, as, obviously, shown in that distributable cash flow growth.

Hall: The dividend coverage ratio came down a little bit. That's not great, but it's still almost 1.4X. This company is clearly generating plenty of cash to more than cover its dividend and support its growth. The company announced a year and a half ago this great dividend growth plan when it consolidated its master limited partnership, rolled those assets in. It's hit every goal that it set so far, and it's on track for basically double-digit dividend growth annually through 2021.

Kind of like Enterprise Products Partners, ONEOK does a lot in gathering and pipeline and natural gas liquids, and natural gas, and some of these more remote plays. It's really done an excellent job of getting fixed contracts for those services, turning that into great cash flows. Management does a great job doing that.

Douglass: Speaking of capital allocation, let's turn to the final midstreamer we're going to cover today, which is Kinder Morgan (KMI -0.05%). I guess I kind of buried the lede here, because this is the one that, when people were writing in, they were probably most interested in hearing about. It's actually a personal holding of mine. Unlike most of the others, Kinder Morgan and its subsidiaries have been in the news. Ticker symbol, by the way, KMI. The Trans Mountain pipeline in Canada has certainly been a lightning rod for political discussions in the last couple of years. It's owned by their Canadian subsidiary, which is a separately traded public company, and it's now being sold to the Canadian government.

Hall: Yeah, definitely a lightning rod, no doubt about it. The Canadian government's relatively progressive when it comes to energy policy. I think, also, as this move makes clear, it's pragmatic. A huge part of its economy is natural resources, whether we're talking about timberlands, the oil sands. With the United States, its biggest neighbor and a huge trading partner, energy is a big part of its economy. This move, frankly, whether we're talking politics or not, I think it's great for Kinder Morgan.

But there's a little bit of complication. This Canadian subsidiary, it's a Canadian company, it's publicly traded. All of the proceeds are going to go to that Canadian subsidiary. It's not like Kinder Morgan can take that cash and use it to, for example, fund its Permian Highway Pipeline that it has in the works. There's a little bit of complication with what it's going to do with that cash.

Douglass: Another reason Kinder Morgan has been in investing news is, a little while ago, they had to slash their dividend so that they could get their debt under control and delever, while also simultaneously funding future growth. A lot of income investors got burned by that. Certainly not great for investors in Kinder Morgan at the time. Certainly, it seems to have been the right call by management, because they've really done a good job of delevering that balance sheet since then.

Hall: It was the only call, if we want to be honest. 

Douglass: Be frank about it, yeah.

Hall: If we go back, over the past five years, of these five midstream companies, the only one that isn't paying a higher dividend today than it did five years ago is Kinder Morgan. Its dividend is substantially less than it was. All of the others have been able to increase their dividends pretty sharply. 

Now, the reasoning is, you could say it's timing, because of the oil crash. We went from $120 a barrel to $26 a barrel in a year and a half. But the company was super aggressive. They were using stock and tons of debt to fund growth, the oil market crashed, all these projects had to come to a halt. And its creditors said, "You want to keep your high credit rating? You have to improve your balance sheet." The only way they could realistically do that is cut the dividend to retain that cash flow. 

I think now is a good time to be looking at the company. The industry is so much healthier. It's doing something different. It's not just trying to go solo on a lot of its projects, like I mentioned, the Permian Highway Pipeline is one that it's looking to have in play by 2020. It's about a $2 billion project, but it has a private equity firm and an oil producer that it's working with to develop it. It's done similar things on the Eastern side of the United States with projects, partnering with other companies. It's going about things in a lot more thoughtful, lower-risk kind of way, in terms of developing new projects.

Douglass: Yeah. And, I'm a shareholder, so I tend to think there are plenty of reasons to like Kinder Morgan.

Hall: I am not a shareholder. I will let you reach your own ...

Douglass: [laughs] Conclusions based on that. Stepping back now, looking at these five companies that are fairly representative of the midstreamers, the big trends here are, everyone's distributable cash flow is up. What they're looking to do is slow their distribution growth a little bit so as to be able to get those core business metrics a lot stronger, and make sure they aren't as reliant on share issuance or debt, particularly in a rising interest rate environment, now that things are looking a little bit healthier. And, of course, Permian, one of the big trends. But also, extensive backlogs of more work that they plan to do so that they can expand those underlying businesses while things are good.

Hall: If you look beyond the Permian and West Texas, there's still need in the Eagle Ford, which is a little more on the eastern part of the state, you have the SCOOP and STACK plays, a lot of Oklahoma needs more infrastructure. Canada, getting oil from the oil sands, getting it to not just the U.S. and the refineries on the Gulf Coast, but getting it to Canada's West Coast, where it can have export access to Asia. There's a lot of growth opportunity. 

The big thing here is, as you were talking about, using cash flows is a big thing in a rising interest rate environment, but also, avoiding the potential of oil prices coming down. Any kind of weakness in demand, because of the cyclicality of the oil industry, can really create fundamental problems with having access to capital. That's why you're seeing those moves, that's why you're seeing things like Enbridge doing some consolidation, that's why ONEOK consolidated its master limited partnership a year and a half ago. I think those moves to simplify businesses and have more steady access to capital are good things that you're seeing, in terms of trends. 

Douglass: Yeah. A lot of reasons to like this area a bit better than a few years back. 

Hey, covering news is great, but we're an investing show, so let's also play the same game we did last week. What's your favorite midstreamer coming out of earnings?

Hall: I've always been a big fan of ONEOK. I think the management has done a tremendous job. They're relatively focused on a geographical basis, and they're really good at what they do. You look over the past couple of years, they've done a really good job of growing that dividend while maintaining solid leverage ratios and strong coverage ratios. Generating a lot more cash than they need to fund the dividend. 

I will continue to like Enterprise Partners and Magellan Midstream Partners until they provide evidence not to. They have great management, they are so solid with capital allocation. 

One thing that's worth mentioning when it comes to these as investments, Magellan and Enterprise are master limited partnerships. It's worth understanding how they pay their dividend out, how it's paid as distribution, to make sure you don't have unexpected tax consequences if you're looking to own them in your master limited partnership. I suggest you go to fool.com and do a search for UBTI, unrelated business taxable income, and check out Magellan and Enterprise's financial filings. Make sure that none of the distributions they pay qualify as UBTI, because you could end up with a tax bill if you own these in your retirement account. So, just be aware of that one thing. Beyond that, ONEOK, Magellan, and Enterprise, I think they're great to buy right now and hold for the next decade and beyond.

Douglass: Very good. I will say, both Kinder Morgan and Enbridge have more question marks around them right now, just because they both have some decisions to make. In Enbridge's case, acquiring the remaining part of Spectra Energy Partners isn't just their decision. Anyway, the point is, for both of them, there are question marks, there are things that could change the thesis incoming in the next few months to year. That's a reason to be a little bit more cautious about both of them. 

But, at its core, this is a good industry to be in. I'll say I've dealt with some of the odd tax situations around energy companies before, so I do tend to personally steer clear of the ones that aren't organized in the way of most public companies. I remember, my taxes used to take me four hours, 2.5 of which was just figuring out one K-1 on an MLP. Ever since then, I've been like, "Let me look for traditionally organized companies as much as possible."

Hall: I've been there. Absolutely. Let me throw you a bone. I'm going to throw you a bone here on Kinder Morgan.

Douglass: You don't have to!

Hall: I'm going to. I think it's important. It's not just for you, it's for our listeners, all thousand of them. I think, when you're looking at midstreamers, generally, you're an income investor looking for predictable dividends that you can count on. That's what I like about the three that I mentioned.

Kinder Morgan is interesting. They pay a solid dividend, but also, this is the one that has a really good opportunity to be a capital return winner. The stock price could really go up. It trades for a very reasonable valuation based on its growth. So, if you're not just hunting income, and you want a potential big-winning stock, and you're willing to take on that risk, it's worth considering. But if you're looking for income, in simplification, the other three are probably your better bets.

Douglass: Sure. Folks, that's it for this week's Energy show. Questions, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about. I, for example, own Kinder Morgan. And, The Motley Fool may have formal recommendations for or against, so, don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Jason Hall, I'm Michael Douglass. Thanks for listening and Fool on!