Magellan Midstream Partners (NYSE:MMP) has a huge 13% distribution yield. It doesn't take much effort to figure out why: Oil prices have cratered from the $50 range all the way down to the $20s. That's a devastating decline for the oil drillers that use Magellan's assets. The thing is, this midstream-focused energy company was already pulling back investor expectations before the price of oil fell off a cliff. What should investors be thinking about here?

A big-picture view of things

Magellan owns the pipelines and storage facilities that help get oil from where it is drilled to where it eventually gets used. Its assets are generally backed by long-term contracts that are based on the use of the asset, not the price of what's flowing through the system. In fact, roughly 85% of this limited partnership's operating margin is tied to fees. In general it is a fairly stable business -- demand for oil and natural gas is more important than the price of the fuels, and demand is likely to remain robust over the longer term.

A man turning valves on an energy pipeline

Image source: Getty Images

That said, COVID-19 is curtailing demand over the near term as global economic activity grinds to a halt. That situation has been exacerbated by OPEC and Russia, which are currently engaged in a bruising price war. Having failed to reach an agreement to curtail production, production has instead been increased. These two factors help explain why oil prices are so low today. This isn't a problem that's going to go away anytime soon, either, since oil can be stored for later use. Essentially, it will take time to work off the excess oil in the system that's being built up today.

What's notable here, however, is that neither OPEC nor Russia really wants oil to be this cheap. What they want is for U.S. shale production to get pushed out of the market. They hope the low prices will speed the process along, sending marginal U.S. oil drillers into bankruptcy court. That's been happening, but not at a fast enough pace -- but this might change things. With oil below $30 a barrel, it will be very hard for smaller U.S. shale companies to keep their doors open -- and onshore U.S. oil producers are Magellan's main target market. 

It was already tough

So far, the big issue for Magellan has been finding new investment opportunities. For example, in 2019 it spent roughly $1 billion on capital projects, but only has around $400 million lined up for 2020. That's a steep drop, and it was largely driven by the fact that oil was hovering in the $50 range. It's hard for energy companies to justify increased drilling at that price, limiting the need for additional midstream assets like the pipelines and storage facilities that Magellan owns. Management claims to have a pipeline of future projects that could be worth up to $500 million, but there are no definite plans laid out.

The problem for Magellan is that in order to grow its top and bottom lines it has to build or buy new assets. If it can't do that, then growth stalls. That's why the partnership is guiding for a modest 3% distribution growth rate in 2020. That's less than half of the 10-year annualized distribution growth rate. More troubling, management has declined to provide any guidance for distribution growth beyond 2020, saying only that it is targeting a coverage ratio of 1.2 times. That's historically been considered strong coverage in the midstream space, providing some support for the payment during times of adversity. 

With oil prices now even lower than they were when the partnership made these decisions, however, the future looks even less clear.

That shouldn't send investors running, however, because there are some positives to consider. For example, Magellan has long been fiscally conservative, with one of the strongest balance sheets in the industry. That hasn't changed, and likely won't anytime soon. Add in the solid distribution coverage and it's unlikely that a short-to-medium-length oil downturn will end up eviscerating Magellan's distribution. 

MMP Dividend Yield Chart

MMP Dividend Yield data by YCharts

Also, the assets that this midstream player owns are serving existing customers. If one of those customers goes out of business, its business is likely to end up in the hands of another energy company. In that case, Magellan's pipes will still be needed. It might have to rework some contracts and future growth projects may be hard to come by, but low energy prices aren't the end of the world -- they are just an unfortunate headwind. Moreover, with regard to customers that muddle through this downturn, many of Magellan's contracts provide for regular, albeit modest, price increases. Thus, there's some potential for top- and bottom-line growth to continue, just slower than in the past.

Lastly, financially strong Magellan could shift gears and buy pipelines and storage assets instead of building them. It prefers ground-up construction, which tends to provide higher returns. But it has made acquisitions before, so there's no reason to think it won't do so again if the oil downturn presents it with some midstream bargains. 

Can you stomach some volatility?

It's hard to invest in an energy company when oil prices look like they could fall to zero, and Magellan's admission that growth is tough to come by today is not a comforting sign. However, Magellan is a financially strong partnership that has managed through energy industry downturns before. And even if it can't build pipelines, it can still buy them from financially weak peers. So it's way too soon to write Magellan off for dead. Conservative income investors looking for a way to take advantage of the devastation in the energy patch should take a closer look at Magellan and its double-digit yield.