The energy industry took it on the chin in 2020 thanks to the coronavirus pandemic. The pain extended into the midstream sector, with even conservative players like Magellan Midstream Partners (NYSE:MMP) and Enterprise Products Partners (NYSE:EPD) seeing huge price declines -- each was off around 30% for the year.
If you're a more aggressive investor, however, you should see this as a buying opportunity -- but only if you tread carefully.
A lingering problem
The biggest issue in 2020 was the pandemic. For the energy sector, like many other sectors, the real fallout was driven by the government-mandated economic shutdowns and social distancing efforts used to slow the spread of the coronavirus. Demand for oil and natural gas effectively declined dramatically at a time when supply was already elevated. Demand still hasn't fully recovered and, compounding things, excess oil has piled up in storage. Although U.S. stockpiles of crude have fallen around 8% from their July 2020 peak, according to the U.S. Energy Information Administration, they remain 3% above where they were at the start of 2020. Working inventories down is a slow process and that stored energy needs to be worked off before the market can get back to more normal supply/demand dynamics.
While that process is slowly moving along, midstream companies like Magellan and Enterprise will likely find demand for their services muted for a while. Further, growth will likely slow, or even crawl to a halt, because new infrastructure investments won't be needed until a more normal environment returns. Meanwhile, the North American energy markets these two midstream players serve is facing an existential threat from the push toward low-carbon energy sources. That effort has taken on a renewed focus with a new administration in Washington D.C., which has already taken steps to limit drilling activity and shut down pipeline construction projects. Of course that may increase the value of some existing infrastructure tied to hard to replace energy products, so there is a potential positive here. But it still changes the dynamics in an industry that has long focused on building from the ground up to support expanding demand.
The big takeaway is that the current energy market is not an easy one, even for boring businesses like Magellan and Enterprise that get paid fees for helping to move oil and gas around the world.
The stronger rock
When facing a difficult period, it often pays for investors to hunker down with the strongest names in the industry. But both Magellan and Enterprise are already conservative by nature. For example, Magellan's financial debt to EBITDA ratio is roughly 3.1 times, and Enterprise's is around 3.6 times. Peer Kinder Morgan has a financial debt to EBITDA ratio of 7.1 times. This is the norm for all three names -- Kinder tends to make greater use of leverage, while Magellan and Enterprise tend to be at the low end of the industry leverage-wise. That said, of the two, Magellan is clearly the more conservative today.
But that's just one metric investors need to consider. Another one is the safety of the distributions paid by each of these master limited partnerships. Enterprise covered its 2020 distribution by 1.6 times. Magellan covered its distribution by a less reassuring 1.1 times. Historically 1.2 times coverage is considered a safe level, so Magellan falls on to the risky side here, while Enterprise could actually withstand further adversity without much risk to its payout. This puts a vastly different spin on the two names when considered in conjunction with the leverage metrics above. Now Enterprise looks like the clear leader.
Enterprise's lead only gets more pronounced when you consider growth. Magellan's capital spending plans for 2021 amount to a scant $75 million, down from nearly $1 billion in 2019. In other words, growth has ground to a virtual halt. Enterprise's capital spending was $3 billion in 2020, and it has plans for capital spending of $1.6 billion in 2021. Growth is clearly going to slow, but not to the same extent as at Magellan. To be fair, Enterprise's 2022 spending plans are about half of its 2021 plans, so the trajectory here is not exactly reassuring. But some growth is better than virtually no growth, which is what Magellan seems to be targeting this year.
There is another factor here that's relevant. Enterprise is one of the most diversified midstream players in the industry, with assets that span the transportation, pipeline, storage, and processing spaces, even including a fleet of ships. It simply has more options within its portfolio. Magellan is highly focused on refined product infrastructure (65% of its operating margin), with the rest related to oil transportation. There's less room in the portfolio for investment, even when times were better.
Which brings us to one last issue: Size. Enterprise is an industry giant with a market cap of nearly $50 billion. Magellan is a sizable entity, with a market cap of around $9 billion, but they are definitely at different sides of the size spectrum. This is notable because, in a slow-growth environment, acquisitions could become an increasingly important way to expand. Enterprise, given its size, diversification, and financial strength, is in a better position to grow via acquisition. Meanwhile, Magellan could actually end up being a target for a larger player looking to goose growth with the addition of reliable refined products and oil assets.
One stands out
Magellan is not a bad midstream partnership by any stretch of the imagination. In fact, investors enticed by its 9.8% distribution yield should probably give it a good examination. The thing is, when you compare it to Enterprise -- despite it sporting a slightly lower 8.2% yield -- the risk/reward trade-off doesn't look as appealing for Magellan. For most investors, Enterprise looks like the better option despite the lower yield, because it also appears to offer notably lower risk.