What happened
Crude oil prices cratered on Monday. At one point, oil was down more than 30%, though it bounced off those lows and was down about 17% at 12:30 p.m. EDT on Monday.
The sell-off in the oil market shook energy stocks to their core, with several, including many of the country's largest oil producers plummeting. Pipeline companies, which typically have minimal direct exposure to commodity prices, also plunged. Among the notable decliners were pipeline giants Kinder Morgan (KMI -0.27%), Enbridge (ENB 0.22%), Williams Companies (WMB 0.24%), Enterprise Products Partners (EPD -0.67%), and Energy Transfer (ET -0.06%). Each one tumbled more than 15% at one point in the trading day.
Image source: Getty Images.
So what
Crude oil prices crashed into the mid-$30s after Saudi Arabia retaliated against Russia following that country's decision to back away from an oil market support agreement. It did so by slashing its oil prices and pledging to increase its output, with the potential to ramp from 9.7 million barrels per day to its max capacity of around 12.5 million barrels per day. The supply increase comes at a time when the market already has an overabundance of oil and demand is weakening due to the COVID-19 outbreak.
The oil market shock torpedoed pipeline stocks due to their direct and indirect exposure to commodity prices. Kinder Morgan, for example, produces some oil in Texas. While it has hedging contracts in place to lock in the price of most of its oil output, about 4% of its cash flow has some exposure to commodity prices. In the company's estimation, every $1 decline in the average oil price this year will ding its cash flow by $5 million. Given oil's recent plunge, it's now more than $20 a barrel below the company's baseline level, implying a roughly $100 million hit to its $5.1 billion budget forecast.
Direct exposure to commodity prices by pipeline companies varies widely. Enbridge and Williams Companies, for example, estimated that long-term contracts and regulated rates would lock in about 97% of their cash flow this year. Enterprise Products Partners and Energy Transfer, meanwhile, have about 85% of their cash flow protected by long-term contracts and regulated rates.
Aside from this direct exposure, another issue weighing on pipeline stocks is the impact lower oil prices will have on volumes. That's because when prices fall, producers need to slow their drilling plans so they don't outspend cash flow. That causes them to complete fewer wells, resulting in lower volumes flowing through pipelines.
Some pipeline companies have take-or-pay contracts in place to offset this impact because those agreements entitle them to receive payment even if customers don't use their allotted capacity. Enbridge, for example, had take-or-pay contracts or similar structures in place underpinning 98% of its cash flow. Kinder Morgan, on the other hand, only has those types of agreements supporting 64% of its earnings.
Those take-or-pay contracts, however, might not stand up if customers don't remain financially solvent. If they declare bankruptcy, for example, the courts could restructure those agreements to help alleviate the financial burden on the shipper.
Now what
Investors are selling pipeline stocks on the concern that the energy sector could be entering another brutal period of activity declines and bankruptcies. If that happens, pipeline companies might not generate as much cash as expected this year, which could make it harder for them to maintain their high-yielding dividends while also continuing to invest in expansion projects.
While that's a risk, these five pipeline companies are among the strongest in the sector. Each has an investment-grade credit rating backed by solid financial metrics, with Kinder Morgan entering 2020 in its best financial shape in years. Because of that, these companies should be able to maintain their dividends even during a prolonged downturn. Further, they could potentially use their strong balance sheets to acquire financially weaker midstream companies, which would benefit them when market conditions improve.
