The midstream energy sector is out of favor today, and offering investors big yields -- think four to five times higher than what you'd get from an S&P 500 Index fund. If that sounds interesting to you, then you might want to take a look at this quartet of high-yield midstream names. But you need to understand why they are offering such high yields, and why they stand out from their peers.
The change is real
Some energy industry watchers see the election of outside directors with a clean energy bias to ExxonMobil's board as a pivotal moment in the energy industry. It very well might be, but the trends underlying this event have been brewing for a long time. Put simply, the world is increasingly looking to reduce its carbon emissions in an effort to slow global warming. The Exxon board changes are just one more sign of the broader shifts taking place.
Image source: Getty Images.
That's potentially problematic for midstream companies. These energy industry players sit between the exploration and production side of the business (upstream) and the refining and chemicals side (downstream), though some actually own downstream assets, too. All in all, the main purpose of a midstream company is to help take oil and gas and move it to the places where it is needed in the form in which it is needed.
If the world starts using less energy, then less oil and natural gas will be flowing through the system. That means less business for midstream companies. And, based on the fat yields on offer in the midstream sector, investors are at least a little worried that this won't be a great outcome for many of the industry's notable names.
A different point of view
That's not an unreasonable takeaway, but energy transitions take a long time. The truth is that oil and natural gas are likely to remain important fuels for decades to come. That means that midstream companies will still need to move oil, natural gas, and the products they get turned into. However, smaller players and those with more focused businesses could start to have an increasingly difficult time. That's painting the industry with a fairly broad stroke, of course, but the real takeaway is that the largest and most diversified names are probably the best positioned to survive and thrive in the midst of a changing energy landscape.
If this is the case, then you'll want to focus on names like U.S.-based giants Kinder Morgan (KMI -0.88%) and master limited partnership Enterprise Products Partners (EPD -1.86%), and Canadian goliaths TC Energy (TRP -0.30%) and Enbridge (ENB -1.26%). All four are huge, ranging from a roughly $40 billion market cap for Kinder Morgan to an $80 billion market cap for Enbridge. All four are also diversified across various niches within the industry and beyond -- Enbridge, for example, owns a natural gas distribution business and renewable power operations, in addition to oil and natural gas pipelines. TC Energy, for its part, also includes electric generation in its portfolio. Kinder Morgan and Enterprise are more focused on oil and natural gas, but have massive footprints and play in various sub sectors.
Size and reach are important, because they position this quartet to be industry consolidators. Indeed, if organic growth via ground-up construction stalls, then the next obvious way to expand is to make bolt-on acquisitions. That said, of these names, Enterprise stands out because of the strength of its balance sheet. Its financial debt to EBITDA ratio is around 4.1 times and at the low end of the group, which is where it has historically lived. Being big, diversified, and modestly leveraged should make it easier for this partnership to swallow up good acquisition candidates. That said, the high-end here is TC Energy at roughly six times, so none of these companies are frighteningly leveraged.
TRP Financial Debt to EBITDA (TTM) data by YCharts
When it comes to the energy transition, meanwhile, TC Energy and Enbridge have already started to dip their toes into the electrification space. That makes them something of a punt option for those that want to hedge their bets on the clean energy future. That said, all four offer huge yields and could help amp up the dividends generated from an income portfolio, with Enterprise at the top end with a distribution yield of around 7% and TC Energy's 5.5% dividend yield at the low end. (For reference, the S&P 500 Index yields a scant 1.3% or so today.)
The future is uncertain, but the direction is clear
While there are no crystal balls on Wall Street, it is pretty obvious that the world is shifting toward a cleaner future. It is unlikely to change overnight, but the change will be a material issue for midstream companies to address. The killer advantage in this scenario is that Kinder Morgan, Enterprise, TC Energy, and Enbridge all have the size, reach, and strength to survive the potential headwinds while shifting toward acquisitions if that proves the most beneficial growth approach. For conservative income investors, this quartet of high-yield names should probably be on the top of your midstream wish list.
