The global pandemic has materially altered the trajectory of the energy industry. Some major players, like Royal Dutch Shell and BP, have suggested it will never be the same again, announcing strategic business shifts toward cleaner energy alternatives.
But what about the midstream companies that own the pipelines and other assets that help move energy around the world? Here's how they can continue to grow even if the future of energy isn't the same as it was just a couple of years ago.
The trend and the bump
The shift toward clean energy energy isn't exactly a new thing. In fact, Shell and Total have been investing in renewable power for many years. Even BP has dabbled in the sector before, so its newest effort isn't exactly out of character. What is different this time is that BP has suggested that the demand for fuels like oil and natural gas are nearing or perhaps past the inflection point and will start declining.
Image source: Getty Images.
To be fair, not all energy companies agree, with holdout ExxonMobil essentially doubling down on oil, explaining that energy transitions tend to be long, drawn-out affairs. So even if the world has seen peak demand for carbon fuels, there's still likely to be demand for the fuels for years to come. However, the global pandemic has left investors in a nervous state.
It's easy to understand why, given that energy demand fell dramatically as countries around the world shut their economies in an attempt to slow the spread of the coronavirus. That resulted in a massive supply/demand imbalance that is nowhere near solved. It was so bad that U.S. oil prices briefly fell below zero at one point in early 2020. Exploration and production (E&P) companies, both large and small, have pulled back hard on the drilling front in an effort to save cash and help resolve the supply issues.
The knock-on effect for owners of midstream energy infrastructure has been reduced near-term demand for their assets. And, perhaps more importantly, a pullback on plans to build the new infrastructure that would have supported all of the capital spending by E&P names that has now been mothballed.
The hit and the solution
To put some numbers on the impact, industry giant Kinder Morgan (KMI -0.32%) started 2020 off with a backlog of investments at $3.6 billion. By the third quarter that had been trimmed to $2.9 billion. Enterprise Products Partners (EPD -0.31%) has canceled three major growth projects, and has reduced its capital spending plans by some $4.7 billion between 2020 and 2022. In 2020 its updated guidance of roughly $2.9 billion in capital spending is actually lower than the low-end of its $3 billion to $4 billion projection when the year began. Peer Magellan Midstream Partners (MMP) has seen its spending drop from $1 billion in 2019 to $400 million in 2020. In 2021 the master limited partnership's projection looks like the company is basically only considering maintenance spending right now, with a budget that's below $100 million.
Midstream companies generally grow by expanding their collection of assets, using the cash generated to pay generous dividends to shareholders. Building new assets from the ground up has long been one of the primary ways to grow. But with demand so low today and the increasing shift toward cleaner energy alternatives, it looks pretty grim on the construction front. The above examples bear that out.
However, that doesn't mean midstream companies can't continue to grow their portfolios. It just means they'll need to go about it in a different way. The main one that investors should be watching is acquisitions. At this point it looks like few companies are buying other companies in the middle of a global pandemic that's upended the energy sector, and that's probably a good decision. However, as the world continues to muddle through the pandemic, a new normal will eventually take shape. At that point midstream players are likely to start looking for opportunities more aggressively.
But not all midstream companies are created equal. For example, $36 billion market cap Enterprise Products Partners has a massive diversified portfolio and a conservative balance sheet. Its financial debt to EBITDA ratio is toward the low end of the industry at about 3.2 times. It's probably in a good position to be a consolidator. Kinder Morgan, with a $26 billion market cap, would likely be a buyer, too, but its 5.7 times financial debt to EBITDA ratio could limit how aggressive it would be.
EPD Market Cap data by YCharts
Both, however, would be better positioned to make an acquisition than a smaller and heavily leveraged peer like Plains All American (PAA 0.84%), which has a $4.8 billion market cap and a negative financial debt to equity ratio because of negative EBITDA. In fact, recent performance might even suggest that a would-be buyer might want to leave Plains off of its list of potential acquisitions. Meanwhile, $7.6 billion Magellan, with a conservative financial debt to EBITDA ratio of 3.4 times, might find itself with multiple suitors.
The takeaway
These are just a few examples in a very diverse industry. While you probably shouldn't invest in a company just because you think it will buy a peer or be bought out, the key points here should be pretty clear. Times are tough today, and growth spending has fallen dramatically in the midstream space. However, even if energy demand is permanently altered, that doesn't mean that growth in the midstream sector is over. It just means that the way companies grow will likely change, with acquisitions playing a more prominent role. And it is likely to be the biggest and strongest that lead the charge. Smaller and financially strong names, meanwhile, are probably the most likely to be swallowed.
